When you start investing in individual stocks, one of the first things that you come across is the old mantra of “Buy Low, Sell High”. In my opinion, there is something very wrong with this principle. Let me explain. 

First of all, what does it mean when you buy a stock? When you buy stock in a company, it means that you are now a part-owner of that business. You can buy stock in any public company such as Starbucks, McDonalds, Apple etc. and become a part-owner of these businesses. That means you will now be able to share in the profits of that business. So every coffee that Starbucks sells, it makes a profit and a part of that profit goes in your pocket. How great is that? 

Let’s say that you start your own business ( a restaurant, bakery or a consulting firm), your objective is to earn profits from selling your product, not from selling your business in the next 6 months and make a profit on that. Right? So why would you sell your stock in the next 6 months at a higher price? Moreover, the stock prices change every day due to reasons that have nothing to do with the business behind the stock. Many factors such as inflation, interest rates, which president is in the office, employment rates etc. affect 

You should only be concerned by how your business is doing and it should not matter to you if the price of your business changes as a result of macro events. Similarly, when you buy a stock, your objective should be to hold that stock for long-term (minimum 3-5 years) and your gains will come from growth in earnings and revenues of that business. In the short-term (less than a year), the share price will change due to macro events on which you have no control. But over the long-term, the price of that stock will follow the trend in earnings and revenues. Understanding this line of thinking that owning stocks should lead you to think as a business owner has been a key lesson in my portfolio management. 

This is how I view investing in individual stocks. Next, I explain about why I like stocks even better than index funds. 

Take a look at this table and you will notice that the S&P 500 index is down about 11% from Jan 2020-June 2020. That’s not surprising because we had experienced one of the worst market downturns due to COVID in 2020. However, you will also notice that the top 10 of the 500 companies are actually up about 9.6% and top 50 companies are up about 2.4%. Rest 450 companies in the index are down anywhere from 5% to 38%. The overall result is that the poor performance by those 450 companies is driving the whole index down. 

Here I want to introduce the Pareto principle also called the 80/20 rule, which states that for many events, 80% of the effects come from 20% of the causes. As you can notice from this above table, less than 20% of the index components are responsible for the majority of the index performance. My point is that if you are able to buy the top companies in the index directly, your returns will not carry the underperformance of the poorly performing companies in the index. 

Don’t get me wrong. I am not saying that you should not buy index funds and just buy individual stocks. I love index funds and am still buying these six funds pretty much every two weeks. I am saying that you should start investing in individual stocks with about 10% of your portfolio and pick stocks that you understand and gradually add to your winners.

As much as I like index funds for investment purposes, I like the combination of index funds and individual stocks even better. In our family portfolio, index funds used to occupy 100%. I slowly started to invest in individual stocks around 2012. I made plenty of mistakes but despite those mistakes, individual stocks now occupy significantly more than 50% of our portfolio and the returns from those stocks far outweigh the returns generated from the index funds part of our portfolio. At the same time, I wouldn’t have been able to handle the volatility in my stock portfolio if it was not for the peace of mind provided by my index-fund portfolio. So, both of these components serve a distinct purpose in my portfolio. Index Funds provide an anchor and individual stocks provide the growth component.

These are the 5 trends that I like and understand. You may like something else. Think about your core competency and is there an industry that you are more familiar with than others? You can pick the winners in that industry such as biotech, technology companies, retail, restaurants, video gaming, alternative energy etc.

One point, I want to double-underline is that you should only continue to invest in individual stocks if you are able to consistently beat the returns generated by index funds. That means that you should score yourself every year and compare the returns generated by your stock portfolio to the returns generated by an index fund (FXAIX is a good benchmark).

The reason I say that is because if your stock portfolio is underperforming an index fund, you are better off just putting your money in a low-cost index fund and not worry about what to buy, and when to buy and when to sell.

What do you think? Should you just invest in an index fund? Or a combination of index funds and individual stocks? Do you compare your performance to an index fund? Feel free to write comments below.