Investing in single stocks is risky because your fortunes is dependent upon one company with the same rationale of ‘all your eggs in one basket’. A well diversified portfolio can reduce your risk considerably.
- Investing in single stocks is risky for a number of reasons.
- Shares prices swing widely and if the underlying company goes bankrupt you often lose 100% of your investment.
- Natural disasters, structural change and poor company management can all lead to the underlying company performing poorly in the stock market.
I am sure many of you can related to a friend, relative, or colleague who has told you about a stock that they have invested in with big potential. With the fear of missing out, its very tempting to go ahead and invest yourself! They are going to make huge returns and you want to be in on it. However, investing in single stocks, or even a few stocks is very risky.
Lets look at examples from both sides of the story. Using data from yahoo! Finance, it is easy to work out, that if you had bought an iPod in 2001, which cost at the time $399, you would now have approximately $60,000. Excellent returns, but you can also find many companies that have gone bankrupt in this time. This is why comparisons like this are always difficult. Apple shares didn’t grow overnight either, in the early 2000’s returns were modest. The big gains came when the fantastic products such as the iPhone and iPad came out, but most investors could not have foreseen this in 2001, maybe not even the engineers at Apple. Therefore, these hindsight comparisons are often not to useful.
Better still, search the internet for some share prices of large companies, it is much easier to find share prices that look like this.
The RBS/Natwest, compared with Apples shares. That look like this across time,
The graphs are screen shots from google.finance.
Lets spend a little bit of time on why shares fall, how can RBS/Natwest group fall from a share price of close to 6000 to as low as they did. Whilst there are many competing theories, the most obvious to us is that the share price was driven away from fundamental value, RBS was never worth this amount per share. Sure, the financial crisis played a huge part, but without doubt investors took the share price beyond its fundamental value. What we mean by fundamental value is the underlying value of the company, what it is actually worth, this is subjective and often to accurate of the stock price, because the stock price is what another investor is willing to buy the shares at. This is why share prices can change very quickly.
What is a financial bubble?
This is what we call a bubble, (ever heard of BitCoin!). A bubble is when the price of a financial asset rises much higher than its fundamental value, eventually leading to a crash. Internet stocks in the early 2000’s where a major bubble, and the housing market in 2008/9.
So why does this happen?
Like we said at the start of this blog post, it is easy for a investors to get carried away and drive the prices up and up. A good example of this comes from the company EntreMed. EntreMed are a well established pharmaceuticals company. In 1998, the New York times covered a front page story on EntreMeds innovation in a cancer drug. With the news, shares jumped from $12 each to $52 dollars. Smart investors where puzzled by this, sure the new cancer treatment was a positive piece of information for the company, but it was old news. Months earlier, the same newspaper reported the same story (at least containing the same information) but this time inside the newspaper and nowhere near the front page. Perhaps this was a slow diffusion of information of news, certain investors where able to digest the information at a quicker pace than others. Or maybe it was another case of irrational investors taking the asset far beyond its fundamental value. It is often difficult to pin point the main reason for the rise and tumble of stocks, but investors getting carried away is certainly common. It is one of the other reasons of why we at InvestinETFs like to avoid the stories that show you how much you would have made investing in Apple shares instead of buying the iPod back in 2001. Does this mean Apple are a good buy now? Whether Apple are a good buy today is dependent on many different pieces of information other than how much you might have made in the past!
So what are my alternatives?
For novice investors, we recommend seeking financial advice from a qualified professional and ask about low-cost index funds (or ETFs), use the other resources on this website to educate, or if you are confidence enough, sign up to one of our free courses which guide you through investing in the financial markets.