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Investing rules for buying individual stocks

May 20, 2020 by Kevin Parker

For our consideration today, let’s group all investors into two categories. Those who contribute money into investments through nothing but an automated contribution system (often taking the form of a 401(k) type plan) and those who contribute money on a non-systematic basis and without a set schedule. Now, it’s worth noting that some investors fall into both camps. Some people have a 401(k), but also throw extra money at investments on occasion.

The automated, systematic contributors have a built-in advantage that the non-systematic, non-scheduled contributors do not. That advantage is that automated investing protects you from you.

While you indeed have control over your 401(k) through managing the contribution level and the investment funds the money goes into, it’s a much more constrained situation compared to a regular brokerage account where you can buy and sell on a whim, put in money at various times and even liquidate your investments at the click of a button. It’s much easier to make big and quick moves through a brokerage account than with your 401(k), and therein lies the problem for many of us. 

It’s not that I don’t advocate investing outside of 401(k) accounts. I have a brokerage account where I contribute extra funds and buy and sell positions within the account. But I’ve learned through both successes and mistakes over the years that extra rules are needed to successfully manage this account. Rules that are kind of already in place for you with the 401(k) type investing. 

So, today, we’re going to talk about setting rules for yourself so that you can more successfully manage an investment account that essentially has no rules or guidelines. These rules are long-term in nature because investing is long-term in nature. While plenty of anecdotal evidence exists for profitable trades outside of a set of rules, there also exists plenty of evidence that these winning trades on a whim are not a sustainable long-term strategy (and in fact, typically lead to dramatic under-performance over time). 

Setting rules on individual stock buying

Our goal is to make money and generate a healthy, sustainable long-term return on our money. I believe that this is most likely possible when you set rules for yourself. So, let’s do that. Our first rule is going to be related to allocation and involve implementing a process for buying stocks. The risk we will be addressing here is what we call single stock risk, or more generally speaking, stock picking risk.

When investing your money into equities, typically we are choosing between some sort of fund (mutual funds, index funds, ETFs) or a stock. Funds are essentially just baskets of stocks that enable you to own a single instrument that provides a good deal of diversification right out of the gate. The passive investing trend has led to immense popularity of index funds where you can essentially “buy the S&P 500.” These index funds mimic and track an index such as a broad market index like the S&P 500 or other various segments of the market such as a specific sector. 

I find index funds to be extremely worthwhile for a number of reasons. They are easy to understand, they are super low cost and you’re getting broad equities exposure. I believe these index funds should be your largest allocation and the backbone of your portfolio. Unless you’re near or at retirement age and your fixed income allocation is quite considerable, investors who still have many years left before retirement should probably have most of their money in simple index funds. 

That doesn’t mean I’m completely against picking stocks. I have a few myself (Netflix being my largest single stock position for years now).  But buying individual stocks should be within a fixed structure that you set up. Again, our goal here is to protect ourselves. 

Our individual stock buying rules are two-fold. First, collectively, our individual stocks are a fixed percentage of our equities allocation. I would say that this should be a maximum of 20% of your equities allocation, and maybe even less such as 10-15%. Secondly, each individual stock should be a maximum of 4% of your entire portfolio and ideally capped in the 2-3% range. 

To demonstrate, let’s look at a few quick examples. An investor has a $1 million portfolio with an 80/20 equities/bonds split. Of the $800,000 equities allocation, $700,000 is in index funds and the remaining $100,000 is split between two stocks: Apple (AAPL) and Walmart (WMT). Is this investor following our rules? While the single stocks collectively make up less than 20% of the equities position, the problem here is that the individual stocks of Apple and Walmart are each over 6% of the portfolio which means we’re failing the second rule we outlined above. This investor can fix the problem by reducing the individual positions of Apple and Walmart to get under the 4% each. That money raised from selling those stocks could be allocated back into index funds or other individual stocks.

A different investor has a $1 million portfolio with the same 80/20 split. Of the $800,000 equities portion, the investor has $600,000 in index funds and the remaining $200,000 is split between 20 individual stocks evenly at $10,000 each. Is this investor following our rules? While the investor does not have any individual stocks that go above 4% allocations, the investor has 25% of his or her equities in individual stocks which is more than our recommended 20% rule. To fix, we’d recommend selling some of the individual stock positions and beefing up the index portion.

Diversification and understanding what’s in your index fund

Let’s talk briefly about diversification. Should an investor attempt to achieve diversification within the collection of individual stocks? I believe the answer is no. Diversification doesn’t need to be the focus because our heavy allocation towards index funds already accomplishes diversification for us. In fact, most investors who attempt to achieve diversification through a picking of 5-10 stocks really aren’t achieving much diversification especially when compared to an index basket of stocks that holds hundreds of companies. So, keep your individual stock selection simple and focused on the handful of companies you know intimately and believe in long-term.

There’s an additional caveat here with respect to individual stock selection. You should be aware of what the largest holdings are in your index funds. For instance, since the S&P 500 index is market cap weighted, a few of the largest companies in the index (today tend to be the mega-cap tech stocks) have very large positions within the index compared to the other companies in the index. 

For example, as of writing, the SPDR S&P 500 index ETF (SPY) has the following listed as its largest holdings: Microsoft (5.66%), Apple (5.08%), Amazon (4.27%) and Facebook (2.04%). So, as you can see, if 80% of your equities is in the SPY, then you’re using the other 20% of your equities to own stocks like Microsoft, Amazon and Apple, you’re being a bit redundant and likely overweighting into these stocks. Just by owning the SPY, you already own heavy allocations in these companies!

Knowing the risks

Before we conclude, let’s briefly address the risks that we’ve been dancing around. Single stock risk typically refers to having a large concentration of assets into a single stock. By doing so, you’re embracing quite a bit of risk. It’s not just the high-flying, high multiple stocks of the day like Tesla that can feel risky. There are countless companies that were considered defensive titans that are now worth a fraction of what they used to be worth (e.g. General Electric). Simply put, if you’re putting all your eggs in one basket, it’s extremely dangerous. Your first goal in investing should be to protect your money!

Next, let’s look at stock picking risk. This is more about your own ability to choose winning stocks over losing stocks. While you might be more talented than I at picking stocks, the data shows that most people fail to pick stocks and produce a collective return that beats the overall market over time. Simply put, your individual stocks you pick probably won’t outperform the index portion of your portfolio over the long-term. This doesn’t mean we don’t pick stocks from time to time. It just demonstrates the enormous need to set rules for yourself as you do.

Your investment rules don’t have to look exactly like mine. The key is just to set some rules. Then write them down and review them regularly. Make sure you’re operating within the framework you set for yourself.

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