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There's got to be a better way

Christine Benz  |  24 Jun 2020Text size  Decrease  Increase  |  
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Last week I wrote the following on Twitter:

"I'll say it: Individual stocks are TERRIBLE investments for people just starting out. I know that many people learned about investing through their Disney shares yadda yadda but I think we need to be clearer about this when we discuss financial education."

And followed it up shortly thereafter with this one.

"So much ink has been spilled discussing the failings of active managers. But we haven't talked enough about how poorly many small investors are apt to do with individual-stock purchases, especially if they're just learning. Now seems like a good time to drive home this point."

Several people seemed to interpret my comments as damning of all individual stock investments, so later that day, I posted this.

"I fear that some are misconstruing my comment. I didn't say that individuals should never buy individual stocks. Rather, that the 22-year-old with a $500 graduation gift is much better off putting the $ into an index fund and reading a few investing books before doing anything else."

To be honest, none of these posts felt particularly controversial to me at the time. After all, diversification has been called "the only free lunch" in investing. Wouldn't most people knowledgeable about matters of personal finance suggest that new investors embrace diversification from the get-go, using an ultracheap total market index or a target-date fund?

Not necessarily. Based on the volume of feedback I received, it seems I touched a nerve.

It's not always about you

As is common with social media, a healthy contingent misread my comments as an assertion that small investors should never hold individual stocks. Several financial advisors said that they've successfully use individual stocks in client portfolios for years. Individual investors discussed how dividend-paying stocks were a big share of their portfolios.

OK, fine. I really wasn't talking about you. If you're an experienced investor with a well-thought-out portfolio that's large enough to be diversified, it's not TERRIBLE if you own individual stocks. But I still assert that the data about active-fund performance should at least be part of your thought process when you develop your investment plan. Yes, as a small investor you do have some key advantages over mutual funds. You're not subject to short-term performance pressures, so you can maintain a long-term mindset; you don't have shareholder redemptions to contend with, which can force fund managers out of names that they might rather hold; you can invest in smaller or illiquid names if you so choose; and you can be more tax-efficient than funds are. But it's also wise to recognise that you're playing against professional investors, people who are paid handsomely to beat the market or at least other funds that invest like they do. If the public track records of those professionals don't make a resounding case for active management (and they don't) what makes you believe you'll be able to do so?

I've seen this movie before

But let's get back to the main point I was trying to address: How should investors just starting out go about investing? This is no trivial matter. After all, we're in an era of young investors experimenting with free trading and the ability to trade fractional shares of individual stocks. And the combination of the coronavirus pandemic (extra free time), the market swoon in the first quarter, and the performance dominance of a handful of big technology stocks appears to have stoked their interest in trading: The number of new brokerage accounts spiked across several brokerage platforms in the first quarter, with well-known tech names gaining the lion's share of new investor dollars.

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I'll say it again. That's a TERRIBLE way to begin investing. While some of these new investors probably have at least a basic appreciation for investment fundamentals, valuation, and diversification, let's be real: Most likely don't. On Internet forums and social media, fractional shares have been touted as a way to obtain exposure to "all of the FAANG stocks"--as if holding Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Alphabet (Google) (GOOG) makes for a well-diversified portfolio. More recently, penny stocks have been having a moment: Investors crowded into dirt-cheap Hertz shares after the firm announced its bankruptcy; the stock price lifted, only to fall again a week later. The website Robintrack, which features data on what Robinhood's investors are buying and selling, shows that the free trading site's investors have been investing in an odd mix of FAANG stocks and beleaguered travel-related names, such as American Airlines (AAL) and Carnival Cruise Lines (CCL).

I know, each market is different. But some of this mania, particularly for the FAANGs, does recall the late 1990s, when investors crowded into "can't-miss" tech names like Cisco (CSCO) and Microsoft (MSFT) in the late stages of their long-running ascent. Microsoft has soared after stumbling badly in the "tech wreck" that ensued; Cisco has underperformed the market. Many other names that soared during that period have been relegated to the dustbin of history. (Remember JDS Uniphase? I didn't, either, until someone referenced it in the Twitter discussion.) I can't help but wonder whether the newbie investor enthusiasm is just the latest in one of many speculative waves we've tended to see toward the end of various market cycles, such as the late-1990s dot-com mania and residential real estate earlier this century.

Are mistakes essential?

Some of the best counter-argurments I saw were that making mistakes can be part of the process. Investors who I respect noted that making their own mistakes with individual stocks had been part of their own investing education, helping them build an appreciation for diversification and maintaining a long-term orientation. They argued that investing in actual companies, in contrast with a broadly diversified fund, made them aware that they were buying small pieces of actual businesses, something that might be lost on buyers of a generic index fund. Others noted that making mistakes when you're investing with small shares of money and you're young enough to recover from them might be part of the process.

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Those are all good points, but I'd also argue that even small sums, invested well, can add up to serious money over a young investor's time horizon; wasting even a few of those early years with misguided experimentation can have a decent-sized opportunity cost. And while doing something is indeed often the best way to learn about it, we're not consistently hands-on in other parts of our lives. If my car started having problems, no one (and I mean it, no one) would suggest that I go out to the garage and try to fix it myself to help cement the value of getting a professional to do it in the first place. Why would we suggest that investors not start with a professional solution first, too?

Simple, cheap, well-diversified

For all of these reasons, I can't help but wonder whether the financial education effort should be more forthright when telling beginning investors about the smartest way to start off with their plans. Too much financial education stays agnostic as to the best way to get started, holding out individual-equity investing and buying a fund as two perfectly legitimate ways to go about it. Indeed, many educational efforts practically glorify speculative stock trading by featuring "the stock market game." Students pick companies to track, often based on limited due diligence (cue the frenzy to pick Apple), then track them for a short period of time. The "winner" is the one whose stock has gone up the most over that short period. Talk about a recipe for terrible long-term investment results.

So if you'd like to help a young person in your life getting started with investing, here's my thought. Give them a check in whatever amount you can afford, along with some instructions about how and where to invest the money. The vast majority of young investors would be better off with a total market index fund. ESG index funds may also be the right thing, depending on your young person's interests. Alternatively, some young investors may have goals that are closer at hand, such as buying a car or making a down payment on a home. If that's the case, those funds shouldn't be in stocks at all; not losing what they've managed to save is the name of the game.

In addition, give them a good basic book or two about money and investing. You probably have your favorites, but some good starters are The Bogleheads Guide to Investing, If You Can by William Bernstein, and I Will Teach You to Be Rich by Ramit Sethi. (I'm particularly enthused about exposing starting investors to what's happening in the FIRE movement so that they understand the interplay between thrift and financial freedom.) If they decide to push forward into individual stocks after that, they'll at least have a basic grounding in how to do it, as well as awareness of what can go wrong.

is Morningstar's director of personal finance.

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