Six Reasons Why You Shouldn’t Pick Your Own Stocks

When I first started investing, it was an overwhelming experience. I didn’t know where to get started and figured that I could just start investing in individual stocks.

I didn’t have a real strategy behind why I was doing what I was doing. I just picked a company that looked like it would be a good investment, and bought into it.

It wasn’t until I started to do some actual research and read up on books that had to do with investing in the market that I realized that I was probably better off not picking individual stocks.

As a matter of fact, practically everyone is better off investing in an index fund or ETF instead of picking their own stocks.

In this article you will discover six reasons why you are better off not picking your own individual stocks.

1. You don’t have the expertise to pick stocks

Picking stocks can be a difficult challenge. It takes a considerable amount of time to understand the market and to learn how to read a company’s financial statements.

Not only do you have to analyze a company’s financial statements, you also have to have a good understanding of a company’s behavior and how it affects the bottom line.

In addition, there are many schools of thought on how to pick stocks. Choosing between these various methodologies can be difficult and overwhelming. Not only that, but some of these methodologies just flat out don’t work.

2. You don’t have time to pick your own stocks.

I know you lead a busy life. If you want to pick your own stocks it will only add to the daily tasks that you to do.

It takes a significant amount of time to manage your own investments. You always need to keep an eye on your individual stocks in the event that something unusual does happen.

You also have to keep track of earnings announcements and other press releases by the company to make sure they are staying on the right track.

Most people don’t have the time or simply don’t want to take this much time with their investments.

3. You want to get rich quick.

Investing in the stock market won’t make you a millionaire overnight. Sure, some people became millionaires during the internet boom of the late 90s, but these people are the exception to the rule.

There were also many people who lost a ton of money in the 90s following the same strategies. They just ended up on the wrong side of the coin.

4. You don’t have the patience

In order to invest in individual stocks, you need to be extremely patient.

You have to be careful with your investment because it is easy to panic if your stock starts to plummet out of nowhere.

Investing in the stock market takes years of patience and discipline. If you aren’t willing to put in that time and effort, don’t pick your own stocks.

5. You don’t enjoy picking stocks

This one seems fairly obvious but if you don’t enjoy picking stocks, don’t pick your own stocks.

However, a lot of people don’t know if they enjoy picking stocks until after they have bought their first stocks. They realize how much time and stress is involved but by the time they realize it, it is too late.

One thing I would recommend is to use a stock market simulator game for a few weeks or even a few month.

Practice picking stocks and tracking companies in your free time. If you actually enjoy finding stocks and tracking them, maybe you are fit to pick your own stocks.

If you don’t enjoy this process, then don’t even think about picking your own stocks.

6. You want to beat the market

Let’s just clarify one thing: you will not beat the market. Many people don’t beat the market.

Professional money managers rarely beat the market. If they can’t do it, what makes you think you can?

According to Brad Barber of UC Davis and Terrance Odean of UC Berkeley, only 1% of active traders beat the market. They concluded that the more frequently people trade, the worse they ended up doing.

Sure it’s fun to imagine being the next Warren Buffett or Peter Lynch, but chances are you won’t be one of those guys.

What should you do instead?

If you aren’t picking your own stocks, what should you do with your money?

My recommendation for those investors is to invest in a total market ETF. My personal favorite is the Vanguard Total Stock Market ETF (VTI).

By investing in this ETF you will have a diversified portfolio which also has extremely low fees compared to other mutual funds.

The Importance of Low Fees

Picking a fund with low fees is important to me and it should be important to you too.

Many actively manage funds have high fees. This means you will have to pay more money which will end up eating into your return on investment.

The kicker is this: most managed funds don’t beat the market.

Remember what I said above about beating the market? Most fund managers fail to beat the market consistently. Why pay more fees for something that’s not even going to give you a higher rate of return.

Why do you benefit from investing in a Total Stock Market Fund?

By investing in a total stock market fund, you experience a couple of benefits.

First, there is much less management on your part. All you have to do is put your money into this fund and sit back and let the stock market do the work.

You don’t have to spend a bunch of time analyzing individual stocks and tracking your portfolio.

Second, there is much less stress by investing in a total market fund. Because your investments are diversified, you don’t have to worry about a single company destroying your investment portfolio.

But what if I really want to pick my own stocks?

Now you know that you shouldn’t pick your own stocks. But what if you still have an itch to pick some individual stocks. What should you do?

One thing that you could do is invest a large percentage of your portfolio in the total stock market fund, and use the remainder to pick your own individual stocks.

This is a strategy that I personally use. I enjoy picking stocks but I don’t like the stress that comes with putting all of my eggs in only one or two baskets.

What I do is invest 60% of my portfolio in the total stock market fund (along with some bond funds) and I use the remainder to invest in individual stocks.

I still get the enjoyment of picking my own stocks, but I don’t have to deal with the risk of having all of my money investing in only a few companies.

Do you pick your own stocks or invest in a market fund? 

Your Fear of Losing Will End Up Costing You Big Time

I was discussing the stock market with one of my co-workers the other day, and we were talking about how stocks are generally overvalued and how the market will have to come back down eventually.

He said “This is why I don’t want to invest in the market right now. Everything is just too high and it’s going to fall eventually. I would rather wait for things to come down to get started.”

I don’t blame him for not wanted to invest everything in stocks right now, but he could invest a small portion of his money in stocks and put the other portion into other forms of investments. Keep in mind, he didn’t invest in the market when it was high in 2007, but he also didn’t invest in 2009 when it hit rock bottom.

It’s not unusual for first time investors to have this mentality

Many first time investors hesitate when it comes to investing. Personally, I spent a couple of years dreaming of investing but never took the leap of faith. What was holding me back those two years is the same thing that holds back many first time investors: loss aversion.

The loss aversion theory explains why many people are afraid to get started. People will make excuses as to why they don’t want to invest in the stock market because they are scared of losing money.

But, this begs the question, when exactly do you plan on investing in the market?

What I saw with my co-worker was a classic example of the loss aversion theory in action. He was so afraid of losing money in the market. As a result, he has not investing in the stock market at all in the past 8 years.

So you may be wondering “What exactly is the loss aversion theory?”

The theory states that people have a tendency to value gains and losses differently. So if something is presented in terms of gains and losses, people are more likely to pick the item based off the gains presentation.

Why do we value gains and losses differently?

This is due to the fact that people strongly prefer to avoid losses rather than acquiring gains of the same amount. In some studies, they have showed that the pain of losing is almost twice as strong as the pain of gaining.

In one example, people were given the option of risking $5,000 to make $10,000 on a flip of a coin. Many people would forgo the gain just so that they didn’t lose any money.

Think about that one for a second. If you could flip a coin and make $10,000 or lose $5,000, would you take that chance? Truth is, you really should take that chance. 50% of the time your will come out ahead with $10,000. What do you think you would do in this situation? Why?

How can you apply loss aversion theory to investing?

The thing about loss aversion is this: it causes people to stay in stagnant positions just so that they don’t have to risk losing any money. Due to the fact that people are so afraid of losing, they will stay in a position that is worse in the long run.

For example, some individuals would stick with losing investments over a long period of time because they don’t want to realize losses. As a result, they will ride down with a sinking ship so that they don’t have to experience the pain of losing…until it is too late of course.

To make matters worse, some people will actually invest more money into a losing stock to average out the cost of their investment. This makes it seem as though the stock hasn’t lost as much value.

How can you avoid the loss aversion bias?

Above I have illustrated two situations in investing that are subject to the loss aversion bias.

The first one being new investors who just don’t get started because they are afraid to lose money.

The second one being experienced investors who hold on to losing stock positions because they do not want to realize losses, which would turn paper losses into actual money losses.

How can new investors avoid the loss aversion bias?

For new investors, it is important to realize that there is some risk to investing in the stock market. You need to understand that your investments may lose value in the short term.

What you also need to know is that the market has been upward trending for the past 130 years and more. You can’t let your fear of losses hold you back from investing.

Another way to hedge your losses is to make sure your portfolio is well diversified. Make sure you have your money invested across a range of stock indexes, bonds, and other investment types. This will help limit your losses over the long haul and make you less likely to lose your money.

Finally, you need to stop worrying and accept the fact that you could lose money. You need to grow comfortable with the fact that your portfolio will have extremely high days and extremely lows days. The most important thing is to weather the storm and not panic on those bad days.

How can experienced investors avoid the loss aversion bias?

My advice for experienced investors is quite different from new investors. New investors are afraid of losing money from the get go whereas experienced investors are afraid of realizing losses on certain investments.

For experienced investors, you need to maintain a long term view of investments. It is important for you to understand how a loss will impact your portfolio as a whole.

One way you can avoid holding on to a losing stock for too long is to place a stop loss order on that stock. This will force you to sell your stock once it hits a certain low point.

Another good thing to remember is that selling investments at a loss will actually help you. When you sell at a loss, you will be able to offset any short term and long term taxable gains.

Final word to experienced investors

Do not hold onto a stock longer than you should. If there are legitimate, solid indications of a sign to sell your stock now, you should absolutely sell.

Now, this doesn’t mean every time a tv pundit tells you a stock is a sell that you should sell it. However, if a company is going through turmoil and revenues and profits are way down, then you should probably sell before it is too late.

You don’t want to hold on to a stock just because you hope it will go up in value. You shouldn’t buy a stock which you hope goes up in value, so why would you have that mentality for a stock you currently own?

What do you think?

What do you think about the loss aversion theory? Have there been times where you didn’t do something because you were afraid of losing? Can you apply this theory to other areas of your life?

Should you pay off your mortgage or invest your money?

Suppose you win the lottery and you win just enough to pay off your mortgage. Should you pay off your mortgage? Or would you be better off investing that money?

In order to answer this question, we must weigh a number of factors. The most important factor deals with your risk profile. You will also want to consider how your current investments are allocated. There are numerous other factors that you must consider. Before we get to all of those factors, let’s make a few assumptions.

Let’s assume the following:

Yeah, I know the saying about people who assume. However, for purposes of answering this question in as full of detail as possible, I need to assume a few things before we dive in and discover my opinion to this question.

The following assumptions are being made:

  1. You have 25 years left on your mortgage so you have a long timeline left to pay it off.
  2. You are in the 25% federal tax bracket, and will remain there for the foreseeable future.
  3. In addition, your state income tax rate is 8%
  4. You current mortgage rate is on par with national averages at 4.5%
  5. You have $200,000 left on your mortgage
  6. You expect the average rate of return of the stock market to be 8% over the next 25 years.

With those assumptions being made, we have the foundation to truly evaluate what you should do with your lottery winnings: invest in the stock market or pay off your mortgage?

Tax deductions make your interest rate lower

The first item that you must consider is that your interest rate is really not the 4.5%. Why is this true? The United States has favorable tax deductions available to homeowners, so your actual interest rate will effectively be lower. What would be the effective interest rate based on our assumptions above?

Your effective interest rate after considering the mortgage tax deduction would actually be 3.105%. How did we arrive at that number? Using this handy calculator at Bankrate, you can easily calculate what your interest rate will be after your mortgage tax deduction.

Go ahead and play with the calculator a bit. It is interesting to see how much the mortgage tax deduction will actually help you. In this example it is almost like cutting 1.4% off your interest rate on your loan!

Paying off your mortgage means no mortgage tax deduction

Why is your interest rate important? This will help us in making our final decision whether to invest our money or pay off the mortgage.

If you choose to pay off your mortgage, you will no longer be eligible for the mortgage tax deduction. You will have to pay more in taxes as a result. But, you won’t be making mortgage payments anymore!

So it looks like a win for paying off you mortgage, doesn’t it? But wait, it can’t be that simple. Well…I guess we have to consider a few other factors before making our big decision.

The opportunity cost of paying off your mortgage

Paying off your mortgage would be a great relief. However, there is an opportunity cost to paying off your mortgage. Ah, opportunity cost, that word you used in economics and never thought you would see again.

By paying off your mortgage, you are foregoing other options with your lottery winnings. What specific opportunity costs can you think of by paying off your mortgage?

The biggest opportunity cost to me is that you will not have that money to invest. This is the biggest opportunity cost in my opinion, so hear me out.

By paying off your mortgage you are taking all of your money off the table to get rid of a huge debt, which can be a relief. However, you will not be able to do anything with that money once to pay off your mortgage.

This brings up an age old question: Should you invest or pay off your debt?

Generally, you would rather invest any extra money when you can achieve returns which are higher than the interest rate on your debts. For example, let’s say you have a loan with 2% interest. Let’s also say that you can make an investment which will return 5% in the next year.

If you choose to pay off your loan, the money will be gone for good. However, if you choose to go with the investment, your money will appreciate by 5%. Now you will have to pay 2% on your loan. As a result, you end up with a net positive return of 3%. Simple enough, right?

The answer is staring you right in the face

Let’s go back to our original example and decide whether you should pay off your mortgage or invest in the stock market.

Based on the assumptions being made, you will be able to achieve an average annual return of 8% in the stock market in the next 25 years. During that same time period, you will be paying an effective interest rate on your loan of 3.105%. You do the math. What will be your total net return of this decision?

Got your answer? Okay good.

I’m sure you answered 4.895% you smart cookie. For simplicity sake, let’s just say you will get an average net return of 4.9% if you decide to invest in the stock market and keep your mortgage as is.

This is precisely where I would stop and not even consider paying off the mortgage. I’m a numbers guy, and the numbers are telling me one thing: INVEST! However, I know that many people aren’t as into the numbers as I am, so I will lay out a few other factors that will help you make your decision.

Factor one: Your risk profile

Your decision will depend heavily on your risk profile. If you like to take on risks and live life on the edge, you would want to invest in the stock market regardless. You don’t care about the fluctuations of the markets, you live for this sort of thing!

Even if you have a moderate risk profile, you would likely opt to invest in the stock market as opposed to paying off your mortgage. Sure, paying off your mortgage would feel good, but you know there is a very good probability the market will return around 8% in 25 years’ time.

If you are extremely risk averse, you will take the sure thing and pay off your mortgage. What if the stock market crashes tomorrow and you lose all your money? You don’t want to take that risk no matter how unlikely it is. You want a sure thing, and the only sure thing is today. You would get rid of that mortgage.

Based on your risk portfolio, what would you do in this situation? Would having a shorter time horizon make you more likely to pay off your mortgage?

Factor two: Asset allocation

Another factor you have to consider is your asset allocation. This will depend on how many assets your had just before winning the lottery.

If you have very few investments, and you choose to pay off your mortgage, you are essentially putting all of your eggs in one back: real estate. This will throw your asset allocation all out of whack, and you will have a high risk exposure to the real estate market. This risk is even higher when you consider you are putting all of your money into one single asset: your home.

If you have few investments and choose to invest in the stock market, you are better able to spread your risk out among number companies, funds, and indexes.

However, if you already have many investments you would not be as impacted by choosing either option. We would assume that you already have a well-balanced profile. Paying off your mortgage wouldn’t expose you to asset allocation risk.

Factor three: Interest rates

In the example above, I illustrated that if you had a low interest rate you would be better off investing in the stock market. I did not consider the factor of higher interest rates.

The interest rate on your mortgage will affect whether or not you choose to invest your money or pay off your mortgage. Logic says the higher the interest rate on your mortgage, the better off you are to pay off the mortgage.

Other factors to consider

Psychological effect of paying off your mortgage early

Paying off your mortgage is a huge accomplishment. For many people, paying off debt is a rewarding experience. You will sleep better at night knowing that your will not have to make to monthly payments every month.

You will no longer have to worry about whether you will have enough money to make mortgage payments. The only payments you will have to make will be for insurance, property taxes, and any miscellaneous repairs and other expenses.

You will have excess cash to invest

While you won’t have the initial $200,000 to invest when you first pay off your mortgage, you will have an extra $1,000 to invest.

While you are deferring compounding interest on your investments, you will also be reducing your risk over time. Having this extra money each month will give you some flexibility for investing and give you extra cash flow every month.

Question to consider:

Would you borrow 3.1% to invest in the stock market?

Answer: for me the answer is a definitive yes. That is basically the decision you are making if you do decide to take your lottery winnings and invest them in the market (again, using our assumptions about market return made above).

What do you think you would do in this situation? Do you think you would pay off the mortgage or invest your money? What other things must you consider before making this decision?