Most of the time, when people buy individual stocks (or choose not to sell ones that they already own), the thought process appears to be something along the lines of: I expect that this company will earn lots of profits in the coming years.

But that’s not a good enough reason to buy an individual stock. (Nor is it a good enough reason to choose not to sell a stock that you already own.)

Choosing to allocate anything more than a trivial portion of your portfolio to an individual stock means taking on considerable additional risk, relative to simply owning a diversified fund of stocks. So you need to have a strong reason to think that this particular stock will earn better returns than the overall market.

And, what most people don’t know is that the performance of a given stock is not determined by whether the underlying company performs well or poorly. Rather, it is determined by whether the underlying company does better or worse than the market expected it to do. There is, therefore, little to be gained from picking individual stocks unless you have some unique insight about the company which the broader overall market does not have — something that isn’t already “priced in.”

A quick litmus test: have you even attempted a financial analysis of the company? Have you looked at their financial statements? Have you done any financial modeling at all? If not, you owe it to yourself to be honest about what you’re doing. You’re investing based on vibes. And you’re pitting that approach, and your money, against professionals who are taking a considerably more rigorous approach to the process.

Another hurdle: if you do think you have a unique insight into this company’s future profitability, it’s important to make sure that you won’t be running afoul of insider trading rules if you make any trades based on the information you have.

But even from that point (i.e., you firmly believe you have a unique insight into the company’s future profitability, and you’re confident that it’s not based on insider information), there are still multiple ways that it can go wrong.

The unique insight you have about the company could turn out to be wrong. A common version of this is, “right line of business, wrong company.” You successfully identified a line of business that grew much faster than the market expected, but the specific company you chose turned out not to be the winner in that industry.

Alternatively, the unique insight you have about the company could turn out to be right, but you were wrong about it being unique. In other words, the market already knew, and the information was already baked into the price.

Another possibility: the unique insight you have about the company turns out to be right, but you weren’t accounting for some negative factor that the market was accounting for (and you were thus overvaluing the stock).

And finally: the unique insight you have about the company turns out to be right, but neither you nor the market was accounting for a negative factor that turned out to be important (i.e., everybody was overvaluing the stock).

A reader writes in, asking:

“Every year, I contribute to my Roth IRA as early in the year as I can and I invest the money right away. But I always wonder about waiting until the price goes down a bit before buying. I think I could even use a limit order to make it happen automatically. For example, buy VTI as soon as its price falls 5% below the current price. It feels like an easy way to squeeze an extra 5% return out for each contribution. Why don’t I hear about people doing this? Is it just because it’s more work or more complicated?”

I often receive emails from newer investors about assorted variations on this type of strategy (i.e., strategies that wait for some specific signal to buy, instead of buying as soon as possible).

The issue isn’t that a strategy like this is more work. The issue is that, on average, a strategy like this isn’t helpful.

With a basic version of this strategy:

• A “winning” scenario results in an additional one-time return of roughly 5% (or whatever percentage “dip” you decide to wait for) due to having purchased at a lower price, and
• A “losing” scenario happens when the market marches steadily upward, such that the intended purchase price never occurs.

And we can see an obvious asymmetry here, in a bad way. With the losing scenario the money never gets invested. You miss out on the investment returns indefinitely. In other words, the upside of the strategy is limited to 5%, and the downside is massive.

So then people often think, “OK, well I’ll also put in place a system to buy if the market goes up by some percentage, so that I don’t miss out on returns indefinitely.”

Let’s say you pick 5% there also. So now you’re not going to invest immediately, but you’ll buy as soon as the intended fund price falls by 5% or rises by 5%.

Well, which do you think is more likely to happen? Assuming you’re buying something that has positive expected returns, it’s more likely to rise in price rather than fall. So now, more often than the cases in which you buy at a 5% discount, you’ll be waiting and instead buying at a 5% higher price than you could have.

You can adjust either of those target percentages however you like, but fundamentally, the effect of wait-for-a-buy-signal strategies is just that: you’re waiting. Relative to investing the money as soon as it’s available, strategies like this reduce the number of days that you’re in the market. So the relevant question is whether the days that you are out of the market have a positive or negative return.

And of course, more often than not, the stock market has positive returns. That’s the whole point of investing in the stock market.

Allan and Bill are each retired.

• Allan purchased 100 shares of Vanguard Total Stock Market ETF (VTI) on November 5, 2021 at a price of $242 per share.
• Bill purchased 100 shares of VTI on September 30, 2022 at a price of $179 per share.

Now imagine that today is February 24, 2023, and the price of VTI $200 per share.

So each person’s 100-share lot is worth $20,000. (We’re assuming here that they each have dividends set to not be reinvested, so that they can use the cash flow for spending. Point being, each person still has the same 100 shares they purchased originally.)

Now imagine that Allan and Bill each have an unexpected expense arise, for which they need to spend about $20,000 from savings.

To Allan, selling VTI would probably feel bad. He bought it at $242, and now it’s worth $200. It feels like he’s “selling low.” Allan might be reluctant to sell this holding to raise the cash needed for spending.

To Bill, selling VTI would probably feel good. He bought it for $179, and now it’s worth $200. It feels like he’s “selling high.” Bill would probably be happy to sell this holding to raise the cash needed for spending.

But the truth is, even though the current price feels low to Allan and feels high to Bill, it’s the same $200 price per share for each of them. They would each be getting the same amount of money, for the same amount of shares.

And, critically, the fund’s future performance is unaffected by the price at which either person bought it. Allan might be tempted to hold on and wait for the fund to recover, while Bill would be happy to sell. But the fund is no more likely to have good future performance for Allan than for Bill.

If you need to sell a holding (either to raise cash for spending, to rebalance, or for any other reason), what does matter is:

• Would selling this holding bring your portfolio more closely in line with your ideal portfolio (e.g., because it simplifies the portfolio, reduces costs, or brings you more closely in line with your target asset allocation), or would selling this holding move you further from your ideal portfolio?
• What would be the tax consequences of selling this holding? (If it’s in a retirement account, there are no consequences. If it’s in a taxable account, it’s actually a good thing if you would be selling for a loss, because that loss can be used to offset other capital gains or potentially ordinary income.)

Some people would add a third consideration to the list, which is whether now is a good or bad time to sell the investment in question. Without getting into a discussion of “does that count as market timing?” I’ll just note that if you want to try make such a determination, it should depend on things like current real interest rates and stock valuations (e.g., PE 10), and it would have nothing at all to do with the price at which you personally happened to purchase the investment in question. Whether the current price is higher or lower than the price at which you purchased is only relevant for tax considerations.

A reader writes in, asking:

“What are your thoughts on implementing a Stop Loss/Trailing Stop Loss for your positions? More specifically, does a trailing stop loss make sense given the added protection against downside risk? I thought it might be an interesting question given the current stock market valuation.”

How Does a Stop Loss Work?

For those who are unfamiliar, a stop loss order is an order that says, “if the price of this holding falls below $x, sell my shares.” A trailing stop loss is an order that says, “if the price of this holding falls by a certain dollar amount (or percentage) from its highest point since I placed this order, sell my shares.”

Example: Bob holds shares of an ETF that is currently worth $90, and he sets a trailing stop loss to sell if the price falls by 10%. That would currently mean that if the share price falls to $81, his shares will be sold. However, if the share price moves upward, the trigger price for his order will move upward as well. For example, if the share price climbs to $100, the new trigger price would be $90 (i.e., a 10% fall from the new high).

Does a Stop Loss Reduce Risk?

To answer the reader’s question, yes, a trailing stop loss is an effective way to provide some “added protection against downside risk.” It isn’t perfect protection, because the price at which the sell order is actually filled could ultimately be lower than the trigger price if the price is falling very quickly. Still, it does reduce risk relative to simply holding something without a stop order.

But, to state the obvious, the fact that something reduces risk doesn’t necessarily make it a good idea. Selling all of your existing holdings and moving everything into a short-term TIPS fund would also reduce risk, but it wouldn’t make sense for most people.

Is a Stop Loss a Good Idea?

Many people first learn about stop orders (trailing or otherwise) and think it’s a simple way to “miss” downward movement. For example: “I’ll set a trailing stop order to sell when the price falls by 10% and then I’ll buy again after it has fallen by 15%. That way I’ll get to miss out on part of the fall while still being able to experience the eventual rebound.”

The problem with this line of thinking is that it neglects to consider what happens if the stock falls 10%, but then rebounds before having fallen by 15%. In such a case, the person has sold their holding but does not buy back in at any point. At some point, they will have to decide whether they want to go ahead and buy back in anyway at a higher price than the price at which they sold.

Moving these two price points closer together (rather than 10% and 15%) does reduce the likelihood of such a scenario, but it also reduces the “payoff” when the strategy works out. That is, it reduces the amount of price decline that the investor gets to avoid.

In addition, on each roundtrip (i.e., selling the holding then eventually buying it again) there are transaction costs that must be overcome in order for the strategy to provide a net gain.

To state the issue another way: A stop loss order essentially says that you don’t want to sell at today’s price. But you would be willing to sell at a price lower than today’s price. For example, I don’t want to sell it today for $100, even though I could. But I would be willing to sell it in the future if the price falls to $90.

This is a line of thinking that does not, in itself, make sense. It only makes sense if you think that prices are predictable. That is, it only makes sense if you think that the lower price tomorrow means that it’s about to go down further rather than going back up. Unfortunately, short-term stock movements are not usually predictable. (This is why strategies that use price movements to predict future price movements are not generally successful.)

In summary, yes, trailing stop orders do reduce risk. But my personal view is that I don’t think most people should bother with them. Most people, if they desire to reduce the risk in their portfolio, are going to be better served by doing it in a simpler manner: by adjusting their asset allocation.

A reader writes in, asking:

“I recently saw an article that said that forex trading was invented to be a risk reduction tool. The nature of the rest of the article gave me the impression that it was just fear-mongering. Make me scared about the fate of U.S. Dollars so I turn my money over to them. But if you could discuss the matter in an article on your blog I’d be interested to read it.”

In some cases — which are rare for individual investors — currency-related investment products can be helpful as a way to reduce risk.

Example: Theresa is a self-employed engineer. She lives in the US (and therefore spends pretty much exclusively in dollars), but the majority of her revenue this year will come from completing a project for a client in the UK — a project for which she’ll be paid £70,000. She anticipates completing the project in October. If she wants to, she could use currency futures to “lock in” the current exchange rate so that she knows how much the £70,000 will actually be worth to her (i.e., in dollars), thereby allowing her to budget her finances accordingly.

Most people, however, are paid in the same currency in which they spend. So there’s no need to offset any such risk.

In fact, for most individual investors, foreign currency trading is not only pointless but also harmful.

Firstly, investing in currency is a zero-sum game, before costs. That is, with forex, the investment you’re holding is a currency (or a derivative product whose performance is based on the price of a currency), and currencies do not actually earn any money. (This is quite different from stocks and bonds, which do on average earn money.) With a forex trade, if one party earns money, it is solely because the party on the other side of the trade lost money. And, after accounting for transaction costs, the total amount earned by the two parties is not zero, but negative.

Second, forex allows for degrees of leverage (i.e., investing with borrowed money) that are truly insane for an individual investor. Forex brokers typically allow for 50:1 leverage, meaning that for each $1,000 you invest, you can buy $50,000 of something by borrowing the other $49,000. Investing this much borrowed money wildly magnifies your results, whether good or bad. Of course, the fact that you can borrow huge amounts of money doesn’t mean you have to. But forex does give you the tools to absolutely destroy your finances in a hurry.

Finally, most individual investors don’t engage in currency trading. As a result, you’re engaging in a zero-sum game (negative, after costs) with people who are, in most cases, professionals. They likely have more experience, better skills, and more information than you have.

A reader writes in, asking:

“I’d love to hear your thoughts on Everbank’s ‘5 Year MarketSafe Commodities CD.’ It guarantees return of principle and offers upside on the performance of several commodities.”

A quick perusal of the CD’s fact sheet (available here) shows three important points:

• The CD is FDIC-protected against loss (i.e., you won’t get back less than you put in),
• You may not withdraw any part of the CD prior to maturity, except “in the event of death or adjudication of incompetence,” and
• The CD’s performance is “based on the performance of six commodities [gold, silver, copper, nickel, soybeans, and sugar.]”

The first two points are pretty straight-forward. The trickiness is all in that last point. If a person read only that statement, he/she might think that the CD provides something like the average return of those commodities, but with no downside (i.e., no ability to lose money), when in reality that’s not the case at all.

Instead, your total return for the 5-year period is equal to the arithmetic average of the annual returns for the commodities in question. (That is, with 6 commodities each having 5 different annual returns, they average those 30 different annual returns, and that average is the total return that you would get.)

For example, imagine a scenario in which each of the commodity prices in question goes up 10% per year for each of the five years. Without taking the time to read the details and work through the math, a person might expect that their CD would match the performance of the commodities. That is, they would expect a 10% compounded annual return, for a total return of 61% over the 5-year period. Not bad for a CD!

But that’s not what you would get. Not even close. Instead, your total return over the period would be 10% (because 10% is the average of the 30 annual returns of 10%).

In addition, the calculation of the annual return for each commodity is capped at 50% each year. And given the volatility of commodity prices, it’s not at all unthinkable that such a limit could come into play.

By way of comparison, it’s currently possible to get a 5-year CD with a 2.3% yield, which would grow your money by a little over 12% over the course of the period. So using this commodity-linked CD instead of a more typical CD would only make sense if:

1. You expect the six commodities in question to increase in price by, on average, more than 12% per year for the next 5 years, and
2. You don’t care about not being able to withdraw your money prior to maturity.

More generally, whenever a product offers downside protection and an upside that is linked to the performance of something very volatile, you only get a small portion of that upside. That’s the case with fixed indexed annuities linked to stock or commodity prices, and it’s the case with CDs such as this one.