When to buy stocks directly

This week, Morningstar's Christine Benz wrote that buying individual stocks was a "TERRIBLE way to begin investing." (All caps, Christine?) Not all readers agreed with her, but as their main counterargument was that losing money teaches novice investors a valuable lesson, their defence seems questionable. Surely there are better ways to learn that fires burn than to put one's hand into a flame.

Besides opportunity cost, the young investor who starts with stocks courts the danger of performing so badly as to become disillusioned, thereby abandoning equities. As Mark Twain said, a cat that jumps on a hot stove will never make that mistake again--but neither will it jump on a cold one. No such worry when buying a diversified fund, when the greatest concern tends to be stifling a yawn.

The math is unfavourable for the direct-equity investor. The stock market indexes are propelled by a relatively small number of huge winners, which drag the silent majority along with them. Over history, the median lifetime return for a publicly traded U.S. stock has been worse than mediocre; it has been negative. Investors who buy individual stocks therefore post skewed results. The happy few perform very well, while the unhappy many lag the indexes--and the index funds.

Owning individual stocks can also bring unnecessary aggravation. My stepmother began investing relatively late, about age 45, by purchasing a blend of funds and individual securities. With the funds, she quickly stopped calling me, except during the most extreme market downturns. But she still calls about her stocks. Whenever one of her companies struggles, she fusses. She would be calmer if she owned only funds.

The starting point

Way back when, people used a technology called "land lines." Sometimes, Morningstar subscribers would call my land line to ask how to evaluate a fund's net asset value, or NAV. One fund traded at $7 per share, while its rivals cost double that amount. Was the cheaper fund a bargain? Or was it discounted for good reason?

Fine questions, for determining whether somebody might wish to own stocks directly. Anybody who makes such queries should not, nor should anybody who responds with an answer other than, "Who cares?" Fund NAVs are arbitrary amounts. Halve the number of shares, the $7 fund is now worth $14. Quarter the shares, it becomes $28. Now it appears "expensive," but remains the same fund, with the same holdings, and the same prospects.

The same logic applies to stock prices, with the additional twist that very low stock quotes tend to be associated with companies that are suffering. Two weeks ago, stocks trading under $1 per share suddenly surged. Some of that performance was rational, as signs of economic recovery boosted the corporate weaklings that often (although not always) have low prices. Much, however, was based on nothing more than numerology, with investors believing that $1 can more easily become $2 than $100 can become $200.

(The most-cited low-priced example, if you haven't yet encountered it, has been Hertz Global Holdings (HTZ), which jumped from $0.83 on June 3 to a high of $6.25 five days later--a 553 per cent gain, which if sustained for a full year would permit the fortunate investor to own a not-so-small island. The stock has since receded to $1.40, which is roughly $1.40 more than most experts think that Hertz is worth, since it currently is engaged in bankruptcy proceedings.)

The head and the heart

Buying penny stocks solely because they are cheap is speculation. So too is the strategy of purchasing stocks because they have already risen, known as trend-chasing. Both approaches can masquerade as insightful if the investment environment is friendly. However, profiting from emotion is unsustainable. Eventually, as with the collapse of the new era technology stocks, those who invest on instinct are punished.

Which brings us, at long last, to this column's headline. The time to buy stocks directly is when the investor has become sufficiently educated (no bargain-seeking with fund NAVs!). In addition--and to echo Christine--these should not be the initial investments. No matter how thoroughly researched, or how savvy the investor, individual equities can misfire. Thus, they should be purchased only after the investor has constructed a foundation of diversified funds.

Under such circumstances, investors stand a real chance of benefiting from their experiences. Buying on whims isn't instructive. Those who err through emotion will make similar mistakes in the future. In time, they may quit the field altogether. In contrast, investors who lose money on stocks that were well-researched and understood will likely learn from the experience. They might make new mistakes, but they are unlikely to repeat their previous errors.

Putting into practice

One reasonable approach is to join an investment club, whereby members divide their resources. This process not only reduces risk by increasing diversification, as a larger asset pool permits the club to own more stocks, but it also encourages analysis. Buying new stocks means persuading other members to accept the decision, and such persuasion is likelier to be obtained by citing analysis than by appealing to emotions.

If one wishes not to join a club, perhaps from fear of groupthink, then individual research is certainly acceptable. But only if rigorously monitored and tracked. Do the calculations; write down the projections; revisit the results. Understanding the investment math is a necessary condition for holding stocks directly, but it is insufficient. The knowledge must be accompanied by discipline.

In summary, Christine was correct. (Words that she will appreciate.) Novices should not own stocks directly, nor should others, unless they have learned the investment curriculum and are also willing to do the work. That is not a very long list. The rest of us (I plead guilty to failing the discipline requirement) are best advised to steer clear. We will be that much duller at parties, but probably also wealthier.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.