Stocks for Show, Funds for Dough

In college I made some money day trading micro-cap stocks. Micro-cap stocks are those with a very small market cap (think garage Microsoft wannabes) and are listed on some of the lesser known, lesser regulated over-the-counter stock exchanges. The two main characteristics of these stocks are that they are extremely volatile, and on average, a micro-cap stock return is negative. As a whole, they do much worse than their much larger, publicly traded, NYSE and Nasdaq exchange-listed cousins.

Traders of micro-cap stocks are either speculative investors hoping to score big on a small company that takes off, or they are people taking advantage of those speculators by using the stock's volatility (and speculators' emotions) in their favor. I was the latter.

I had a method figured out that seemed to work consistently. It worked consistently enough that I considered dropping out of college and day-trading full time. Ultimately there were several factors that kept me in school to finish my engineering degree. I'll spare you the details because this article isn't about me, it's about you - especially if you are a person that invests heavily in individual stocks.

I will often mention my experience in day trading to demonstrate that I understand two extremes of the investing world. One extreme in which constant vigilance, skill, and care are required in order to squeeze a few dollars out of the stock market. This extreme provides for a grand show filled with stories about winning and losing thousands of dollars within minutes. This isn't all that far from individuals who will regale others with tales about investments they've made providing triple-digit returns.

The other extreme is boring; it is the story of passive investing in which we diversify our investments appropriately among several asset classes and more or less forget about them while they make us dough.

We all remember who won the race between the tortoise and the hare. Unless you're Warren Buffett, investing in individual stocks is equivalent to betting on the hare.

People love to talk about their stock-picking wins, but will rarely talk about the ones that have lost them money. For every Amazon, Netflix, and Apple success story out there, there are just as many unspoken Circuit City, America Online, and General Electric failure stories.

There are several reasons an investor will invest in an individual stock: he or she believes that stock's value will go up because the company is undervalued or will grow at a rate faster than the rest of the economy. An investor can become emotionally involved with a particular stock, often because they've held it for a considerable period of time, follow the company, or made significant gains (or losses) over the course of several years with that company. This happens with those who invest heavily in the company they work for, which is a huge mistake that I wrote about here.

As a former day trader I'll acknowledge that betting loads of money on a company is much more fun than making responsible decisions like investing in an index fund. It's a cocktail of excitement and emotions with a dash of the Dunning-Kruger effect! Combine that with your retirement savings and stir - what could possibly go wrong?

Plenty.

I will advocate for investing in individual stocks if your goal is to learn or have fun and these investments are limited to 5% or less of your entire portfolio. I recently encouraged my six year old son to choose a stock to invest in with his piggy-bank savings. He wanted to buy 1 share of Tesla, but as it turns out these are currently too expensive to buy with what he's saved so far. So he's a proud Ford shareholder instead.

What he doesn't yet know is that some number of years down the road, an important lesson in the ongoing family class of saving & investing will be the importance of diversification. We'll take a look at his modest investments over the years and see how they compare against some of the best passive index funds. Because at the end of the day, if your goal is to make money, study after study has shown that funds outperform investors picking their own stocks.

Don't be a sucker. Invest in low cost index funds.