Investing in individual stocks is risky. “Both large and small investors should stick with low-cost index funds.”1 Never get involved in a land war in Asia.
You don’t need to convince me of these truths – I am a big fan of what index funds represent. I don’t have much of an “edge” to beat the market, and I believe many individual investors who attempt to pick stocks are setting themselves up for failure.
And yet, a majority of my equity holdings are in individual stocks. I expect that trend to hold for my entire investing career.
How can I possibly reconcile “picking stocks” with a pretty efficient market and little to no real advantage in identifying winners? It turns out that even if you accept an index mindset, there are advantages to holding individual stocks.
Low Expense Ratio
One of the great advantages touted for index funds is really low annual expenses. You can buy an equity index ETF with an annual expense ratio less than 5 basis points (.05%). That’s pretty low.
However, the annual expense ratio on my individual stock holdings comes in at a cool 0 basis points (0.00000000000000%).
To be fair, you can buy an index fund ETF with a single trade commission, and sometimes (if you buy your own brokerage’s) those trades are themselves free. I have to pay a trade commission for every stock I purchase, and if I were taking small positions in each company, those commissions would add up fast. But I pay $4.95 whether I’m buying $500 or $50,000 in shares, and at the higher levels, the commissions are negligible.
Individual stock positions may therefore have a slight cost advantage over index funds once your pile is big enough that you can get to your desired diversification without a mountain of trading costs.
But the saved expense ratio is small bones compared to the biggest advantage I see in holding individual stocks. Taxes are where they really shine.
Tax Advantages of Individual Stocks
Losing money when you sell a stock or index fund isn’t fun, but at least there is a silver lining: you can potentially harvest those losses to offset gains on other sales, and you might even be able to use losses to offset a small portion of regular income (say, from your salary). (Remember to always check the current IRS rules and get help as needed from a professional for any tax issue – tax loss harvesting is not for amateurs).
Given that, let’s consider two scenarios: one in which you buy an ETF that tracks the S&P 500, and one in which you buy individual stock positions that mirror the S&P 500.
There will be many winners and losers in the S&P 500 over a stretch of time, but in the ETF, the winners and losers will largely cancel each other out – it will be a much smoother ride than the individual stock positions (that is the benefit of diversification, after all). Over time, if history holds, the ETF would go up, and you would just owe a capital gain if you ever sold it at a profit. Your tax loss harvesting opportunities would likely be small or nonexistent.
If you instead invested in each individual stock in the index, you could have many losers and many winners, and that presents an opportunity. You could sell losers either 1) to offset the allowed amount of regular income or 2) to wipe out a gain on a winner you no longer wanted to hold. Over time, you could get a real economic benefit from “harvesting” the losses of the losers and (mostly) sitting on the gains of the winners. Of course, your changing holdings would quickly move you away from tracking the index, and you’d eventually end up with a much more concentrated portfolio of just some of the “winning” stocks. You would also end up with a higher unrealized capital gain than you would with a single ETF index investment.
This strategy – harvesting losers and sitting on winners – is what I’ve done a lot in my taxable account. It’s certainly not effortless, as I have to pick individual stocks and stay within the rules for harvesting losses. I’ve also grown some significant individual stock positions, but I’m OK with my current exposure. I’ve always felt that a modest investment growing into a huge position is a nice problem to have.
There is, of course, the issue of the big and ever-growing unrealized capital gains on these “winning” stock positions – they are much bigger than if I had just invested in an index fund. But I have a secret: I’m not planning on paying capital gains tax on them at all.
I’m not going to break any rules, though. I’ve got another trick up my sleeve: I’m going to die.
I don’t have immediate plans to die, but I do think it’s somewhere in my future. And if I precede the missus in shuffling off this mortal coil, she’s going to have a tax windfall (and vice versa). All of those fat unrealized capital gains? Gone! The tax basis for all of my winners should step up when I die, and she can sell them instantly and put everything in a (wait for it…) index fund.
If we have some really low income years in the future, we may be able to take some of our capital gains tax-free before we die, but the step up in basis from dying is a great backstop.
I know many index lovers who are huge fans of tax loss harvesting, but the harvest is more plentiful when you’re working with individual stocks.
You Can Still Be Diversified
The instant diversification provided by an index fund is one of its greatest features, but it is possible to be diversified with individual stocks. It’s just more work.
I feel fairly well diversified with ~20 stocks across a broad swath of industries with some sizable ETF index holdings to boot. The Diversification Police might still find fault, especially given some rather large positions in individual companies, but I sleep fine at night.
In addition, a stock portfolio which has every ounce of diversifiable risk diversified away has never been a goal for me. I definitely want to spread my bets, but given how my stock portfolio is already far more diversified than many of my other assets, pursuing some sort of stock diversification nirvana provides diminishing returns.
Some folks are terrified of holding individual stocks but will happily dump a fortune into an index fund. As long as you take a portfolio approach to your individual holdings and embrace an index mindset, the two shouldn’t be that different.
Do I Have An Edge?
One strong argument against picking stocks is that an individual investor has no chance for an informational advantage, or “edge”, in making investment decisions. I largely agree with that statement.
I will never be able to out-analyze the financial analyst community – I may have the ability, but I can’t and won’t put in enough time. A hedge fund making million or billion dollar investments can justify a lot more financial analysis than I can with my much more modest punts. If I spend hundreds or thousands of hours optimizing a $20,000 investment, I might even achieve a market-beating return, but I’ve surely failed the 7-11 test.
However, that doesn’t mean I’m hopelessly outclassed and should accept defeat. It means that I just need to focus on areas where I might actually have some advantage and readily concede everywhere that I don’t.
I’ve found that my most successful individual stock investments come from when I disagree with the “market” on something meaningful and there is a reason that I might have good information.
I’ve had some success with distressed situations where I felt the probability of bankruptcy was lower than the market seemed to assume. As a former turnaround consultant with a deep background in credit analysis and a highly contrarian nature, maybe I do have a tiny edge.
I’ve had roaring success investing in video game stocks. In the past, I’ve actually interviewed store associates and young punk customers to help build my knowledge of the space, and of course the thousands of hours of product testing I’ve done help too. In terms of identifying long-term industry trends and picking who may benefit from them, perhaps I have a slight edge.
It could be that I have no edge at all and have simply been lucky, but since I largely embrace an index mindset and sharply limit the active punts I make, I think I’m going to be OK.
The risk in picking individual stocks isn’t in finding an edge. The real risk is thinking you have an edge when you don’t. I would be happy investing in a broad portfolio selected by a chimpanzee throwing darts, but I would not be happy investing in one that the chimp chose using his financial analysis skills.
What If Everyone Indexed?
A final argument for individual stocks is philosophical. If everyone is doing something, I typically like to do the inverse. And index investing is hot right now.
My fantasy is a world in which every single person is an index investor. Then I’ll find a few great companies that aren’t a part of any index and buy them all for a song (since no one wants them, they should run cheap). Yeah, my fantasies run kinda tame.
Consider a company that has just been added to the S&P 500, one of the most popular indexes around. When the company is added, every single fund that tracks the S&P 500 index needs to buy that company’s stock. That bids up the price of the stock and increases its market capitalization. And remember what the S&P 500 index is? That’s right, it’s market-cap weighted. Since an index is supposed to passively reflect what’s going on in the market, that circularity worries me a bit.
If the ubiquity of index funds starts materially changing stock prices and market returns (and perhaps it already does), investing outside of the most popular indexes could be a good strategy.
The Spirit of Indexing
Index investing is an excellent strategy because it provides cheap and easy diversification and saves investors from themselves.
Some people should probably invest 100.0% of their desired equity exposure in a low-cost index fund. Others with a clear edge in picking stocks (e.g., Warren Buffett) should invest 0.0%.
I fall somewhere in between. For me, indexing versus individual stocks is definitely a shades-of-gray affair.
The spirit of indexing – diversifying, not missing market returns, and not thinking I’m smarter than everyone else – dominates my investment strategy. However, the execution of that strategy, due to some unique advantages over index funds, will always include a healthy dose of individual stocks.
Picture courtesy of Ulrike Mai
1 Warren Buffett in Berkshire Hathaway’s 2016 annual report letter.