Risk and return are inseparable.
If there is the potential to earn a greater return, there is also the potential for a greater loss.
Let’s look at how this risk/return relationship works by comparing the purchase of an individual stock to the purchase of an index fund.
Suppose you feel confident that XYZ stock is currently undervalued. You work in the industry, the company has a steady history of growing its revenue, and it produces a consistent, high quality product.
The stock price has recently gone down by 50%. You are positive that in the next twelve months, it will go back up by at least 50%. (In dollars, assume the stock went from $60 a share to $30 a share. You are confident that it will, at a minimum, go back up to $45 a share.)
The stock market as a whole has also gone down. The S&P 500 Index fund in your account has gone down by 40%. It went from $60 a share to $36 a share. You know markets are volatile, but you never expected a decline like this in an index fund, and you are trying to figure out how to recoup your losses.
You decide that it might take the market several years to recover, but if you sold your index fund and bought XYZ stock, your portfolio could recover faster.
It sounds logical.
The problem is, the market as a whole, and thus your index fund, will not go to a zero value. Your index fund will not one day be worth nothing.
XYZ stock on the other hand, could continue to go down in value, and in a worst case scenario file for bankruptcy, leaving you with nothing.
For a personal perspective on this topic, read What Would I Do, Buy Individual Stocks Or Stock Index Funds?What could cause XYZ stock to continue to slide? Numerous things such as:
- A lawsuit against the company due to a defective product
- A decrease in sales/earnings because a competitor comes out with a product that is much better.
- An accounting error or misstatement that caused the company to overstate earnings
If you buy XYZ stock, you may get lucky, and the stock will go up faster than the market. Or you may not get lucky, and the stock could continue to go down in value; even all the way down to zero.
If you keep your index fund, you know the market will recover. Your potential for rapid gain is not as great. However you have eliminated the possibility of a complete loss.
When it comes to individual stocks, there are analysts, company insiders, investment managers and other bright and capable people evaluating that stock just like you are. If a stock price appears to be too low, you have to stop and ask yourself, “What is it that the market knows about this stock that I don’t know?”
I have personally had numerous occasions where I bought stocks that appeared to be “no brainers”. Within a few short weeks, the dividend was cut, the loss of a key customer was announced, a lawsuit was filed, or some other such detrimental event came about that caused the stock to either go down more, or at best, left its price stagnant for many years.
If you’re going to buy individual stocks, be conscious of the risk you are taking.
- If the positive outcome you are hoping for occurs, how much better off will that leave you?
- If a negative outcome should occur, how much worse off would that leave you?
Do the potential results from a positive outcome justify the risks of a potential negative outcome?
Just remember, if it is a stock are familiar with, you will think that a negative outcome is impossible.
In 2001, we watched Intel executives refuse to diversify, and we watched their stock holdings go down by over 70%. Many of those executives bought additional stock, insistent that it would bounce back. In 2008, seven years later, it still has not recovered.
