Most investors should generally invest in low-cost, diversified mutual funds. Yet many
strive to find the next Microsoft or Wal-Mart in order to make a big killing. We
recommend that our clients invest in well-diversified portfolios spread across nine
different broad asset classes. We recommend they buy low-cost mutual funds, index
funds and/or exchange-traded funds (ETFs).
Mutual funds and ETFs provide professional management and broad diversification.
Financial advisors generally believe that investors need at least ten or twelve stocks to
provide sufficient diversification. Even if an investor has several individual stocks in
their portfolio, they typically are heavily weighted in the U.S. stock market. Domestic U.
S. stocks are but one of the nine asset classes we feel investors must include in their
portfolio in order to be sufficiently diversified.
Four of the nine asset classes we recommend are stock oriented (often also referred to
as equities). Therefore, if you wanted to pick your own stocks, you’d have to find 10 or
more stocks to purchase in each of the four different stock asset classes (a total of 40
or more). Not only would this be a lot of work, but it requires substantial skills to
research and pick quality stocks.
Unfortunately, many investors’ methods of choosing stocks leave a lot to be desired.
They get a hot tip from a friend, relative or coworker. They read about a stock in Money
Magazine that has already run up in value by the time they buy it. Or, a broker
recommends a stock to all their clients. If you’re the first to receive their
recommendation you might do well. If you’re one of the last, you could be buying at a
high price.
So, if you must invest in stocks, how should you go about it? Investments clubs offer
individuals the opportunity to learn about investing fundamentals and usually take
considerable time to analyze a stock before they vote to buy it. Be cautious, however.
Make sure the club follows a sound methodology and sticks to its bylaws. Be careful
that your club does not become a social gathering where members share their “hot
picks” obtained at cocktail parties or across the backyard fence.
If you really want to do it right and invest the time, read the classic book by Benjamin
Graham, The Intelligent Investor, Fourth Revised Edition, published by Harper Collins,
1985. Sage investor Warren Buffet studied under Graham and used his teachings to
guide his investment picks in the hugely successful Berkshire Hathaway. Graham’s
book, however, is not for the novice. It can be quite technical and is not an easy read.
Consider a recent book by Pat Dorsey, Director of Stock Analysis at Morningstar®, the
mutual fund-rating company. Dorsey’s The Five Rules for Successful Stock Investing,
John Wiley & Sons, Inc., 2004, is an outstanding book that could be described as a
layman’s version of Benjamin Graham’s book. It is a much easier read and lays out a
sound method for identifying companies that are well managed and whose stocks are
attractively priced. The only problem is that following the process outlined takes a lot of
time and energy. You’ll have to be committed enough to have the perseverance to
complete the entire analysis. Plan on making it your new part-time job.
If you’re still determined to invest in stocks, what should you do? It turns out that the
methods outlined in Dorsey’s book are similar, albeit less rigorous, to the methods used
by Morningstar to analyze individual stocks. Morningstar’s Premium Membership for
stock information provides a rating scale of one to five stars, a fair market value
estimate, buy and sell recommendations and analyst reviews. At $15.95 per month or $
145 per year, it’s a relatively inexpensive way to obtain good information to use as a
base for stock selection. While a good place to start, the Morningstar data is not the
end-all for stock investors. As with all other approaches, there are still many risks to
deal with (e.g., corporate fraud, litigation, new competitors, to name a few).
Once you’ve decided on a stock, you need to decide on a price to buy and a price to
sell. Investors typically never set a target price for selling. They often fail to capitalize
on gains and often hold on to losers until they’ve lost nearly everything. They need to
understand that it takes a 100% gain to wipe out a 50% loss. Stock investing takes time
and expertise to be successful. It’s OK to play around with a small sum of money, but if
you want to invest a significant amount in stocks, be prepared to put in the time to do it
right.
So, if you must invest in stocks, do your homework. And, if you don’t have the time, stick
to low-cost, broadly diversified mutual funds and ETFs.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, with offices in Waterford and Royal Oak, Michigan. Visit www.
pattersonadvisorsllc.com for more information.
Published in The Oakland Press OurTown Online Clarkston, July 2007 &
the Oakland Insider, October 2007
If You Must Invest in Stocks
By David and Erin Patterson