I’m always amazed at how many personal finance blogs recommend investing in index funds. There was a recent post at Money Q&A where Hank asked 12 personal finance bloggers where they would recommend an investor put $1,000.
And out of the 12 bloggers one said individual stocks and the rest effectively said an index or mutual fund.
Sure, I think that an index or mutual fund is better than stuffing dollars under your mattress, or having inflation eat away at them in a savings account, but a lot of people are really missing out on the chance to build real wealth.
Up until 2006 I was investing in index funds. I only had a few thousand dollars then and what I always heard and read was to invest in them. So I invested my few thousand dollars in the Fidelity Spartan 500 Index Fund (was FSMKX, now FUSEX).
I do agree there are certain benefits to investing in an index fund. First, the management fees are close to zero because there really is no management to do. When you buy an S&P 5oo index fund – which consists of the top 500 publicly traded companies in the US – I am pretty sure a computer does all the work, and computers work for free!
Second, there is no work to do for the investor. You can rest assured you will own the top 500 stocks, period. Considering these two factors, I do agree that for someone new to investing it’s a decent way to dip your toe in the water.
But before I delve into why I think investing in individual stocks is a much, much better way to build wealth I have to divulge that investing can be complex and is certainly controversial. It’s not black and white and it’s not for everyone. It can be scary because you can lose your shirt, your pants, your house and even singe the fur off your cat. But, if you have the time, curiosity and patience to learn you will succeed. And you will beat the index funds.
I realized a while back that there were 3 ways to reach my goal for my Walk Away Money Pile (WAMP). Or generally speaking, there’s 3 ways to get rich: Start a successful company, inherit it, or invest. I’ve never been interested in starting a company and as far as I know I will never receive any sort of substantial inheritance (although I am definitely open to this). So, investing was going to be my jam.
1. You get the lousy with the great
We don’t want to put money into a stock index fund that represents a cross-section of US businesses, some good, some average, some lousy. We want to find and purchase shares in great companies with the potential to compound their earnings year after year. Patient shareholders, like myself, have witnessed this firsthand. And let me tell you it’s pretty cool. There’s been rough patches a long the way, times I’ve seen my portfolio take huge hits, don’t get me wrong. Here’s a chart to prove it:
But I maintain my bullishness on stock investing over the long term. As you can see, even though I have had some of my businesses go through tough times, my portfolio is always trending up. And not all of my stocks will crush the S&P 500 – the benchmark I use to compare my stocks to – but I think that the majority will, and have.
2. Diversification, as you know it, is not good
I believe in diversification. But I believe in it across time, various economic conditions and by buying stocks at better multiples. I mainly invest in restaurant and retail stocks because they are easy to understand. And as I study them over time I become more familiar with them. I can see what affects their share price and what affects their earnings. Why their guidance changes. How many stores they are going to be able to build to know where they are in their growth cycle. I begin to see patterns.
With this knowledge I am able to exploit the short term traders, selling on the news or after a weak quarter. I am a Long Term Buy Hold (LTBH) investor so I don’t look short term, I take the long view. That means a decade.
A new investor may think that diversifying across industries will protect them from ignorance. And that’s a great point! For example, if the restaurant and retail sectors falter because of high oil prices, by being invested in the energy sector it will act as a counterbalance. High oil prices means energy stocks will be higher.
And you can get instant diversification with a fund. But since 2000 funds haven’t really done that well. The Fidelity Magellan flagship fund (FMAGX) has underperformed the S&P 500 in that time:
And the S&P 500 has had dismal returns as well:
I always thought that the mutual fund companies preached diversifying with funds as a strategy to promote what they were selling. I think you can do just fine with a portfolio of 10-20 individual stocks, all restaurant and retail, and really crush the S&P 500.
3. Sacrificing returns for perceived safety
Many investors never leave the index funds because it’s safe. But I think they take this too far. And randomly picking a few companies from various industries is no good either, frankly it’s downright dangerous.
Restaurants and retail stores are very easy to understand and invest in, that’s why I like them. They are predictable and their prospects are very visible. You do not have to have a lot of stock market skills to do well if you stick to easily understood industries like restaurants and you can value them based on the Price to Earnings (P/E) multiple.
I have no idea how to value a bio-tech company or a semiconductor manufacturer so I will never invest in one. But a restaurant, that’s easy! Plus, I like to eat so I like the fact I can roll into a Chipotle or Whole Foods and say, “I own part of this!” notwithstanding the weird glances from other customers.
The bulk of my portfolio is invested in these companies: Apple, Amazon, Chipotle, Coach, Google, Lululemon, Netflix, Priceline, Panera, Starbucks and Whole Foods.
Let’s check out the performance of shares in the restaurants I own versus the S&P over the last 5 years:
The retail stocks over the last 5 years:
And finally the tech companies over the last 5 years:
All these companies are (mostly) easy to understand. They have great leaders at the helm. They have visible growth prospects. They are killing the S&P 500. And they are positioned to beat the S&P 500 in the long haul.
With all that said, I hope you think about if index or mutual funds are the right fit for you. For some, they will be and that’s perfectly fine. You can shovel cash into them and effectively outsource the management of your investing. Your portfolio will grow.
But, if you have an interest in stocks and want the opportunity to crush the market over decades, I would highly suggest investing in individual stocks. While it can be a little scary going it alone, think about signing up for a service like the Motley Fool Stock Advisor where they offer stock suggestions and have forums for discussion. This is a really great path for new investors.
Additionally, before you buy your first share read investing books. A good first one is One Up On Wall Street by Peter Lynch.
I think one of the reasons I have had a good experience investing in individual stocks is that I am genuinely interested in investing. It takes time to learn and I will be learning about investing for the rest of my life, but I truly enjoy it.
Someone recently asked this and I wanted to answer it:
Why would I take $1,000 and invest it in only one share of Apple (AAPL)?
That’s a valid question. Apple currently trades in the $600’s and just because you only have enough money to buy one share doesn’t mean it’s silly to do that. There is no difference between buying 10 shares of a $60 stock or 1 share of a $600 stock. Shares are irrelevant. You still have $600 invested and if the shares of the $60 stock go up by 5% to $63 you’ve made $30 ($3 x 10 shares). If the shares of the $600 stock go up by 5% you’ve made $30 ($30 x 1 share). I’d rather invest in a great company like Apple, even if I can only buy one share, than a sub-par company because I can buy 100 shares.