My commentary about investments has normally centered on the overall stock market. For someone investing in a 401K plan at work, other than employee stock, purchasing equities involves buying a fund of securities rather than individual companies.
However, if you have an individual IRA account, or own non-retirement assets you do have the option of buying individual stocks.
While investing in funds is best for most people because of the diversification provided, buying individual stocks can certainly supplement a portfolio. When you have individual stocks you are not paying a management fee, though fees for index funds are relatively low. Having individual stocks gives you more flexibility in regards to tax planning, as you can take gains and losses when it is advantageous.
In selecting stocks much of the same analysis that is used in purchasing income producing real estate can be applied. For example stocks normally sell in a range of 10 to 20 times annual earnings, just as a rental property may be priced at 10 to 20 times the yearly rent.
Obviously if you can purchase something towards the lower end of that range, it is preferable to paying a premium. The one caveat would be cyclical companies, such as homebuilders, auto manufacturers, and commodity producers. They may appear inexpensive based on current earnings, but that may be because their profits are at a relative peak, and will soon start to decline.
In addition to valuation it is important to look at the business prospects of a company. As consumers we can generally tell which products and retailers are having strong sales. What becomes more difficult is to determine how well products will sell in the future, especially for devices that experience rapid change, such as consumer electronics.
Apple has been an immensely successful stock, as the company has enjoyed strong sales and robust profit margins, since it charges premium prices. However, it is uncertain if Apple will be as dominant 5 years from now, as they are today.
Safer investments tend to be in areas where there is little change, such as beverages and utilities. Five years from now Coca Cola will likely still enjoy its dominant position, especially in international markets, where it derives the bulk of its profits.
On the other hand, in five years the market share among cell phone manufacturers will probably be significantly different than it is currently.
This does not imply that investing in one industry is preferable to another. Only that investing in industries where there is greater uncertainty about the future the potential for both larger gains and losses is greater than in more stable areas.
However, if someone is more risk averse he/she should gravitate more towards established companies in more stable industries.
Clearly if someone is uncomfortable buying individual stocks he/she should stick with funds. It is also important for someone who invests in individual stocks that they stay properly diversified. Being diversified is not just owning a significant amount of companies, but investing across different industries.
However, if someone’s holdings of individual stocks are only a minor portion of their overall portfolio, then being diversified with the individual stocks is not that critical. Investing in individual stocks might not be for everyone, but it does offer the opportunity to enhance a portfolio to your particular objectives.