Ways that Owning Individual Stocks Can Go Wrong

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).