How to Invest in Stocks

According to convential wisdom, long-term financial planning and investing for retirement for individuals should consist largely of mutual funds, bonds or bond funds, and cash equivalents like treasuries or money market funds. The general idea is that owning individual stocks is too dangerous for retail investors because of the inherent risks of not being diversified. The risks are simply the overall market risk (the Dow Jones Industrials, the S&P 500, Nasdaq), sector/industry risk (technology, health care, utilities, etc), and then individual company risk (bankruptcy, scandal, poor management, steep competition, et cetera). Some financial advisors go as far as saying that unless you have at least a million dollars (USD) in assets in retirement accounts, you shouldn’t touch individual stocks. That’s stance is too cautionary...

What is a Mutual Fund?

red_hat_investing_cloud_stocks_individual_mutual_funds(94115)Since a mutual fund is a basket of individual stocks, potentially some bonds, cash and sometimes a few derivatives for hedging purposes (options, futures, etc) -- it can give you instant diversification either in the whole market or in a particular sector, market cap, or region. Since mutual funds have fund manager(s) whose job it is to beat their benchmark -- or the overall market -- you can feel that the investment choices are being made deliberately. The downside of mutual funds is the selling of portfolio holdings or redemption of mutual fund shares by other investors that will incur changes in the fund that effect everyone. And contrary to popular belief, professional fund managers are not all great stock pickers. 

Where is Your Investment Portfolio Diversification?

But if you have a 401K or 403b at work, an individual IRA or Roth IRA retirement account, you likely have only mutual fund, bond, and cash equivalent choices. This is probably good, and it provides a foundation of diversification to help in both good and bad market moves. if you must select mutual funds for your core retirement assets -- even if you just choose index funds that track the overall market -- you’ll then be free to add individual stocks in other  accounts. This can be in a Roth IRA account if you meet the conditions, a separate taxable portfolio account that you have ‘earmarked’ for retirement, or in a dividend reinvestment plan (DRIP) or direct stock purchase plan (DSPP)

Choosing Individual Stocks for Your Portfolio

If you have had good luck and solid returns so far with your mutual fund choices, you might be reluctant to start adding individual stocks to your investing plan. We can’t all be Warren Buffett and choose the greatest stocks for long-term buy and hold, but since our other assets protect us from major turn-downs in the market, it’s often fine to select single company holdings based on our interests and research. 

Two of my current work retirement mutual funds include the Fidelity Growth Fund (FDGRX), a large cap growth fund, and the Baron Small Cap (BSCFX), obviously a small cap fund which is also geared toward growth. If I am happy with these funds, their returns, fund managers, and more -- I can use these assets to give me ideas for my individual stock holdings. 

Using Mutual Fund Data to Help Me Invest Wisely

According to data on Fidelity’s website, Fidelity Growth Fund (FDGRX), at the end of last year held Apple (AAPL), Exxon (XOM), Google (GOOG), (CRM), Discover (DFS), Red Hat (RHT), Qualcomm (QCOM), Elan (ELN), Nvidia (NVDA), and McDonalds Corp (MCD) in its top ten holdings, accounting for more than a quarter of its total holdings. How does this help me select individual stocks?

I could decide that I agree with the fund managers and think that being in some of the best cloud computing technology stocks like Google,, or Red Hat would be a solid move and then choose to buy more for my own account. Why? If they decide to sell, trim back, or take profits at the fund -- I will no longer be exposed to these stocks if I don’t have my own holdings. Isn’t there a risk of having too much? For example if I wanted to purchase Red Hat for my Roth IRA (today 4/11/12 at $59.23 per share) wouldn’t I have too much exposure since it’s already in this fund?

Since the Morningstar site now shows the top 25 holdings of FDGRX (more recently - as of the end of February 2012), we notice that some other stocks are now in the top 10 -- and other stocks have moved around -- some likely from purchases, others from price appreciation. We notice that Red Hat has moved from number six to number eight on our list, but it still only accounts for 1.76% of the portfolio (shown as the overall portfolio weight). This means even if you have $50,000 invested in this single mutual fund, you only have about $880 exposure to Red Hat (or the equivalent of about 14 shares). If you really believe in this company, investment story, sector, etc -- you could easily purchase additional shares of RHT in your Roth IRA without throwing off your diversification, especially if you have other assets. 

Having just $880 exposure to a single company is great if they go bankrupt, but won’t move the needle if they do really well in a growth industry, sector, or market. Fidelity Growth’s top holding at the end of February was Apple, on a real tear this year, but at only 7.9% of the portfolio would account for $3950 in our hypothetical $50,000 fund holding, or the equivalent of six (6) shares of Apple. A full year’s Roth contribution of $5000 could get almost 8 shares, which might be more what you want long-term.

Fund Holdings Might Suggest Other Sectors

You also might decide that since these two funds have so many growth stocks (largely tech in the Fidelity), and some telecom and consumer stocks in the Baron Small Cap -- that I should perhaps buy value stocks for my individual holdings. This is what we did with our dividend reinvestment plans (DRIPs), buying Kellogg Co (ticker symbol: K) first to offset all of our Nasdaq-driven technology holdings in our various accounts. Since Kellogg is a 19B market cap company with many iconic brands, and a dividend of about 3.21% -- we feel that there is less risk in holding Kellogg than leaving the money in our bank’s money market, and getting less interest than inflation. Remember to always weigh the percentage of any holdings, especially individual stocks, against your entire assets (in all your accounts), and maintain a balanced ratio that you can be comfortable owning.

(Disclosure: Of the stocks and funds mentioned, the author owns FDGRX, K, AAPL, GOOG, RHT, and BSCFX, at the time of this writing. Remember to always consult your own advisors before purchasing any investment.)