Why You Shouldn’t Buy Individual Stocks

The stock market is complex enough without these added problems

Allan Roth,

AARP

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En español

Published March 17, 2023

A confident guy holding dart takes a flying leap towards a dartboard's bullseye.

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When it comes to investing, you’ve probably heard this advice countless times: Diversify! As an adviser, I’ve given this counsel innumerable times, and I couldn’t agree with it more. When you own thousands of stocks in a low-cost index fund, you have far less risk than if you own a handful of individual stocks. I’ve written about former blue chips like General Motors, Eastman Kodak and GE that lost most or all of their value. Though this should be reason enough to avoid individual stocks, here are five lesser-known reasons.

1. You’ll probably earn less

Intuition tells us that roughly half the stocks will beat the total market and half won’t. But intuition is typically wrong when it comes to investing. A 2020 study by Arizona State University’s W.P. Carey School of Business evaluated lifetime returns for every U.S. common stock traded, and 96 percent earned about the same as a one-month Treasury bill. A handful of stocks drive the return of the stock market. The stars of yesterday are unlikely to be the stars going forward.

Betting on a few select stocks may make your rich if you choose the right ones, but the probabilities are against you. Just as a lottery ticket may make you rich if you win, the overwhelming odds are you will lose. Experts are often wrong, as illustrated by Mad Money’s Jim Cramer touting the stock of Silicon Valley Bank weeks before its failure.

2. Proxy voting

Publicly traded companies have an annual shareholder meeting. Chances are you won’t be attending, but you will have the opportunity to vote a proxy for such items as the composition of the board of directors or even selling the company to another entity. I personally have never met anyone who takes the time to read the multitude of pages and research the issues in a proxy. I’d argue that if you own a dozen or more individual stocks, you could spend the entire year researching the issues and board nominees.

If you own through a diversified low-cost fund, you don’t have to do anything. That’s because fund families, like iShares, Vanguard, Fidelity and Schwab, give the shareholder a voice by researching for you.

3. Stock spin-offs

A publicly held company can spin off part of its business into a new publicly held company. An example of this is GE spinning off its health care business earlier this year. Not only do shareholders have an additional stock to keep track of, they will likely have to calculate a new cost basis when they sell. That’s because part of the original cost basis belongs to GE and part to GE HealthCare. If your brokerage company holds the security and if you bought it after 2011, they will keep track of this for you, but at the very least, this adds to the complexity.

4. Rights issues

For various reasons, some companies issue the right to buy more shares of their stock. It’s essentially an invitation to shareholders to buy additional shares, often at a discount. Deciding whether or not to exercise or even sell these rights requires a very complex analysis. If many investors exercise their rights and the company issues a significant amount of new stock, your shares will be less valuable, all other things being equal. If you do exercise your rights, you have to invest more money in the stock.

5. Class action suits

Quite often in America, companies are sued on behalf of shareholders for such things as issuing misleading information. To participate, you may have to fill out lengthy forms and provide data about when you bought the shares and for how much. That requires a lot of work for what may turn out to be only a few dollars. The fund can do all of this for you.

Many of these reasons not to buy individual stocks are complex, which is yet another reason not to buy them. But as I write this article, I’m feeling a little pain, because I’m one of those fools. This is going to sound just a bit defensive or rationalizing, but I buy an occasional stock to have a little fun. I call it my gambling portfolio, and it exercises a piece of my brain that craves some thrills and chills but doesn’t impact my family’s goals.

To illustrate why this was foolish, let’s look at my purchase of Xerox Holdings (XRX). I bought a small amount sometime after the dot-com bubble burst in 2000. I no longer have an easily obtainable record of my purchase price, since I moved the shares to a different broker and it didn’t carry over. Although I bought the stock after it had plunged nearly 90 percent, it has been one of those 96 percent of stocks that has been a dog. Then, at the start of 2017, Xerox Holdings spun off its business process services company, called Conduent (CNDT).

To make matters worse, I received a notice last week of a class action suit. To participate, I’d have to spend quite a bit of time. It probably isn’t worth it. Can it get worse? Sure. For a time, Conduent was considering spinning off another company, which would create even more complexity.

I have the vast majority of my stock investments in ultra-low-cost index and diversified index funds. Yet even the small percentage of individual stocks I buy in my gambling portfolio to fill that thrill-seeking need makes me a bit of a fool.

My advice

Get your excitement from somewhere other than investing. Let a low-cost total stock index fund give you diversification and a greater likelihood of higher returns. Let the professionals read the proxies and legal work and do the associated research. You have better things to do.

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Allan Roth is a practicing financial planner who has taught finance and behavioral finance at three universities and has written for national publications including The Wall Street Journal.