Investment Pyramid - Concentrated Investments

When we left off last time, we were looking at the joy and wonder of investing in mutual funds. For most people, this is about as far as they need to go in building up an investment pyramid. It might be a flat-topped pyramid if you are following my little diagram below, but there's nothing wrong with that. But, if want to keep building up your pyramid, the next step is to look into individual stocks:


I like to call these 'concentrated investments' because they aren't diversified (and I'm a chemistry dork, so I think in terms of concentrated and dilute). This can be a good thing; if your investment goes up, you'll make much greater profit by holding a single stock than owning it as part of a diverse mutual fund. The flip side, of course, is that if the stock goes down, or if the company goes bankrupt, you'll be take a much greater loss holding the stock directly compared to having hundreds of stocks in a mutual fund.

Try to limit how much money you put into stocks; it's easier, much easier, to lose all the money invested in individual stocks than it is to lose the money that's in mutual funds. Start with a small portion of your portfolio in stocks (10% to begin with), and then, as you gain experience, you can expand that amount upwards, should you desire. If you're going to invest directly in stocks and bonds, be sure to keep a few things in mind:

1) Be sure to do lots of research - individual stocks and bonds require a lot more attention than mutual funds (especially if you stick with index funds). If you invest in individual stocks, you need to closely watch the company in which you are investing, or you might end up holding another Lehman Brothers as it takes down a large portion of your portfolio. If you aren't willing or able to look over your stocks weekly, investing a significant amount of time studying the companies in which you are investing, you simply will not do well.

2) Learn to read financial statements - in the same vein, understanding how to read the numerous financial filings that companies need to make with the Securities and Exchange Commission (SEC) is important when you want to invest in individual companies. Being able to read and understand a 10-Q or 10-K form (to say nothing of knowing what they are) is vital for investing in individual companies. If you haven't learned how to read financial statement, the SEC can show you the way.

3) Consider your asset allocation - if you're investing in American, large company stocks ('blue chips', as they are frequently called), you should probably cut back on the US stock funds you hold. That way, you'll remain diversified, even as you expand your holdings into individual stocks.

4) Know your risk tolerance - investing in securities can be a harrowing experience; stocks go up and down daily, sometimes for fundamental reasons (the company itself is doing well or doing poorly) and sometimes for emotional reasons (stocks are bought and sold by people, and people react emotionally). As a result, there will be movements in the stock price, sometimes dramatic, and there could be times when it seems like the company might go under. If you aren't prepared for this, if you haven't thoroughly studied the stock and have the stomach to face harrowing drops in the stock price, you're going to be much better off investing in safe index funds and letting your investments ride.

5) Be sure to buy and hold - investing is all about the long term; it's about where you end up, not what happens along the way. Buy stocks with the idea of keeping them for the long term. You can invest for capital growth or for dividend payments (or both), but look toward the long term. Trading weekly, or even daily, will drive up your commissions with your brokerage firm but will be very unlikely to lead to higher profits for you.

6) Tune out the noise - one of the biggest obstacles to simply buying and holding is the sheer amount of chatter you will encounter, whether on TV, in newspapers, or online. Learn to tune it out; finding, buying, and holding quality stocks for the long term is the best way to make money from individual stocks. At best, shows on CNBC or online stock pickers can be sources of ideas as to where to begin your investing, but you shouldn't buy or sell without doing hours of your own research.

7) Consider sector-specific funds - finally, if you're looking to get more exposure to a particular subsection of the economy, there are ways to get it without buying individual stocks. A mutual fund (or ETF) that invests in a particular sector of the economy can give you a way to invest in financial stocks, for example, without having to invest in individual stocks. These sector-specific fund give you a greater margin of safety, while still letting you participate in the weakness or strength of a particular part of the greater economy.

Following these rules should help you to expand your holdings beyond mutual funds. If you still need more excitement in your investing life, though, you can always look into speculation. And by sheer coincidence, that's the subject of tomorrow's blog article!