PITFALLS OF INDIVIDUAL STOCK INVESTING

I had a friend in college who was a Finance major and he landed a banking job after we graduated. We lost touch for the first couple years after graduation, but reconnected on the train platform at Grand Central in the busy hustle and bustle of rush hour commuting one evening in 2007. Over the next few months we would spend everyday sharing a train ride home while we were jammed like sardines in a can. It was during these train rides, that Carl revealed his passionate obsession for stock trading. I would listen to him recount his major successes of investing $15,000 in a stock on Monday and by Friday he would execute a sell trade and walk away with $20,000. He would always recite, "There's no other place you can legally make this kind of gain except in the stock market". No matter how much he loved highlighting his victorious wins, Carl was careful to highlight the downsides of individual stocking trading, which as he would say "Left him without his Shirt". In other words, every trade didn't lead to successful money gains. On the contrary some trades were total blunders that left him at a loss so great, that he would probably die before he can claim all the losses on his taxes (The government allows you to carry losses forward up to a certain amount annually).

It was Carl's excitement for the wins that motivated me to take a stab at this stock trading thing. I wasn't hoping to get rich but I wanted a chance to tell a story of a successful money win just like Carl. He had a knack for buying stocks during earnings seasons (the period in which companies release quarterly performance info). If you think back to 2007, Research in Motion (the company that made Blackberry phones) dominated the cell phone space. Carl convinced me that this stock was a winner for that particular earnings season. So I established a brokerage account with Scottrade just in time to buy $5,000 worth of shares of Blackberry stock. After earnings were released I had a gain of $800 in 2 days. To say that I was riding a cloud was an understatement. I finally had a small story of success to share.

UNTIL....

I started to lose all the gain within a couple weeks. Suddenly I couldn't focus on work, I couldn't sleep and I couldn't think. At that point all I wanted to do was protect my $5,000 investment. Eventually I got rid of the shares because I wasn't strong enough to handle the volatility of the market. It would take 8 more years before I would give stock trading another go around. This time it was on the heels of the much anticipated Alibaba IPO (Initial Price Offering). This experience would teach me that the talked about IPO price isn't the price regular investors get by the time the market opens. The IPO price was $68 and I bought in at $98 within a couple mins of the market opening. I had another success story on my hands because 2 months later had a $4,000 gain on my initial investment. Until earnings season approached and Alibaba posted less than expected earnings and the stock went south from $121 down below $90. Not only did I lose my gain but I lost some principal. Somewhere along the road while the stock was tanking, I bought Apple to hedge my losses. While Apply gained, Alibaba tanked. Eventually I sold both stocks and recovered my principal.

While I didn't lose much money in both cases, what I did lose was sleep and my general sense of calm. It's no fun being glued to your computer everyday watching the stock market do it's funny dance with your money tied in somewhere. These experiences taught me a few lessons that are critical to highlight:

INEXPERIENCE: In hindsight, I should've locked in the gains and sold my shares, making both plays good short-term moves if that was my strategy. However, I didn't really have a strategy because I didn't know what I was doing. First of all, both experiences in the stock market were based on the whimsical feeling of my dear friend Carl. I didn't do the research in company fundamentals nor did I check their balance sheet. I went in both times hoping to make a quick gain. I didn't educate myself about investing basics like knowing and understanding the importance of my risk profile, asset allocation, diversification nor did I even consider my investment time horizon. Simply put....I was INEXPERIENCED. If I had to give advice to anyone who wants to invest, I would urge them to know and understand what they're investing in. Don't put your money in investment vehicles you don't understand just because it may have worked for someone else.

RISK - Buying individual stocks is purely speculation, thus increasing your level of risk. In both cases I owned one stock at a time which means there's a chance I could lose all my money. According to a study by Longboard Asset Management which assessed stock performance from 1983-2006, 64% of stocks underperformed the Russell 3000 Index (a broad index of US stocks) and only 25% of stocks accounted for market gains. So the next time whimsical Carl has a good feeling about a stock, how would I know that that stock is a winner? I don't know, so I won't buy it. I'm not interested in the level of risk that keeps me up at night or unable to focus at work because I'm too busy watching the market do its funny dance with my money. There are other ways to invest in the market that will provide gains (albeit not quick), while minimizing overall risk.

MARKET EFFICIENCY:  I would later learn that holding individual stocks indicates that I expect the stock to outperform the market. Then I became familiar with a phrase called Efficient Market Hypothesis which is an investment theory that states that it's impossible to beat the market because stock market efficiency causes existing share prices to incorporate and include all relevant information. In other words, stocks trade at fair value and all investors have access to the same information making it impossible for anyone to beat the market. Carl's explanation for picking certain stocks often seemed magical and special, but he was just making good guesses that sometimes worked out and other times didn't.

I'm not merely suggesting that holding individual stock as part of an investment portfolio is the worst thing in the world but it should probably represent a small portion (maybe 4%) of your overall portfolio from purely a risk management perspective. In my case a single stock represented 100% of my portfolio which goes against the very basics of investing. In recent years Carl has called me at least 3x to invest in stocks he felt were winners. He called me when Tesla was $85, and had I listened I would've doubled my money when the stock hit $220. When the country was experiencing the Ebola scare a couple years ago, Carl called me and told me about the company that was manufacturing the protective gear that healthcare professionals were using for precautionary measures. Back then hospitals were ordering in bulk quantity. The stock was $14 that Tuesday night and by that Friday Carl had doubled his money. When oil prices were on a sharp decline, Carl was watching 2 oil ETF's (Exchange Traded Funds) that had an inverse relationship to each other. Carl made  a play in one of them that gave him a net gain of $28,000 in one week. I beat myself up when I think about these missed gains, but I was just too afraid. And if past experience means anything, I'm just not ready to handle the risk that comes with individual stock picking.

 In my next post, I'll talk about how to invest in the market to achieve diversification while spreading your overall risk to create the wealth my previous posts have referenced.

Have you experienced success and/or failures with individual stock picking? What's your current feeling on investing in the market?