This is a guest post from Kevin over at 20smoney.com.
Please allow me to introduce myself. My name is Kevin and I have been writing for 20smoney.com for five months now. 20s Money is a blog dedicated to providing advice for all things money to people in their 20s. Such topics include investing, careers, stocks, real estate, income streams, planning for retirement, etc. My view is that investment advice is not the same for stage of life. A 20-something looking to get a jump start on the wealth building process requires different advice than a 55 year old nearing retirement. 20s Money addresses the unique challenges and obstacles that a 20-something must overcome today in order to reach his or her financial goals.
Today, I’d like to discuss an approach to investing that most financial advisors or bloggers do not frequently address. A quick look at the typical investment advice out there for young people overwhelmingly reinforces the idea of putting money each month into a diversified index ETF or portfolio of ETFs. While this is by no means an incorrect approach for an investor, it may not be for everyone.
What about an approach for a young investor, like myself, who wouldn’t mind a bit more risk and who enjoys more active effort and involvement? Since the inception of my blog, I’ve met plenty of investors whose desires mirror my own. Let’s examine such an approach.
This investing approach hinges upon finding a few individual companies to invest in instead of an over-diversified index fund. This approach aims to outperform the market, hoping to have more positions with large returns than positions with losses. This approach requires more effort and a stronger stomach for potential volatility. I’ll say it before we get into details, this approach isn’t for everyone.
The most important aspect of this investing approach is stock selection. Your goal is to find three or four solid investments for your portfolio. We don’t want more positions than that because we want each investment to have meaningful stakes. Over-diversification leads to too many positions each without “meaningful stakes” and the gains and losses tend to cancel each other out.
If this approach makes you nervous, consider finding companies in different industries to help protect you from a potential losing sector or industry. Also, perhaps consider not having all growth stocks. Combine a value play with a nice dividend yield along with a potential growth play. For an example portfolio of three stocks, read my post on Where A Young Investor Should Put Five Grand.
If you struggle finding individual stocks, start following a few companies that an analyst or expert that you respect recommends. Everyone has their picks, make sure it’s somebody you already respect. Jim Rogers is that person for me. He is an investment professional with a phenomenal record.
Re-Defining Dollar Cost Averaging
Many financial experts will recommend continuously adding money to positions each month. I think this is too frequent. If you are paying trading commissions, you are accruing too many fees. I say, add to your positions once or twice a year. I would recommend adding to each of the three or four positions each time, but not necessarily adding the same amount of money to each one. If a sector is down, you may decide to add more to that position since it’s a better entry point. By having fewer yet consistent contributions to your positions, you are still dollar cost averaging but with more flexibility.
Identifying The Risk
Most experts tell young investors to stick to diversified ETFs and index funds because you aren’t smart enough to pick your own individual stocks. This may or may not be true; however, you may want more flexibility than simply buying the entire S&P each time you put money into your position. Maybe energy is way down over the last few months, and you’d like to put more money into that than one of your other positions that is possibly due for a correction.
I want to build strong individual positions that can potentially deliver large, long term returns. Sure, you may get killed on one of your positions. The great thing about being young is that the money you probably have to invest isn’t that much compared to your overall net worth down the road. If you put a few thousand bucks in each position and lose 40% (horrible) on one of your positions, you might lose $1,000 or so. Now, say you double down on natural gas today because it’s down so much and it rebounds big. Your position goes up three-fold over the next few years. Your gain will definitely outweigh your loss.
To conclude, if you are up for a challenge, a little more effort in selecting individual stocks, and are willing to stomach some higher risk, now may be a fantastic time for your to build your own portfolio of some select individual stocks. Stocks are down, so you might have some great entry points for some great companies. My goal is to hit it big on a few positions while minimizing my losses on the others. I’m willing to take small losses while shooting for the “home runs”. I understand the risk and feel to get where I want to be financially, I need to take a shot at this investment strategy.
My question is, how is your over-diversified portfolio or S&P index performing over the last few years? I think we overestimate the broad market returns we should expect over the long term heading forward. Many credible economists believe our economy and stock market may be entering a low growth period with smaller broad market returns. Perhaps they’re wrong. Perhaps they’re right. If they are right, my approach of finding individual stocks at least has the potential for large returns. If they’re wrong, then I still should benefit somewhat since some of my stocks will benefit from the overall market trend.
Only you can decide what approach is best for you. Make up your own mind. Understand the risk/reward of either strategy and commit to an approach, even in a down market. Good luck investing!
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
Very Nice and helpful post thanks for sharing it with us..
I'm in this age group, but I disagree with this advice. I don't think we can pick stocks that perform better then the index over the long term. I also don't want a second job trying to find good stocks to buy. There are other advantages to indexing as well such as lower taxes, lower fees, no need for a financial advisor (most of which suck), no guilt about buying a bad stock, or worry about when to sell if you are high or low.
If I had to give advise to a 20 something I would say this is absolutely the best time in life to save money like a fiend. Keep your costs low, you don't need or deserve a new car or an iPhone. Live like a starving college student for a couple years and you will quickly build more wealth then you could possible get from the stock market.
Also stay away from debt, avoid credit cards, don't owe anyone anything. If you have debt, you would do better to pay it all off before saving $1 towards building wealth. If you want to be a roller buy everything with cash, it will keep your spending honest. If you avoid debt from the beginning you should only need to borrow money once, to buy a home.
Speaking of home, stay at you're parent's home as long as possible and save 50% or more of your income. Even one extra year living under your parent's roof could easily add $10k to your investments.
I find this very useful for all age groups, we have seen more older people lose focus. I do agree with Jimmy, and go with at least ten stocks to a well diversified portfolio.
I'm living proof this strategy works. Buying companies like Apple, Google, or China Mobile paid off big time when I bought them 5 years ago.
Diversification is a necessary evil, but it can also hold you back. Look at how well those well popular index funds have done over the last 10 years... pull up a decade long chart of the S&P 500 sometime if you want a nice laugh.
I do recommend this strategy. But I would also suggest to diversify a little more than with just three stocks. I would go with at least ten stocks to have a well diversified portfolio. Three seems a bit risky.
This advice isn't just for twenty somethings. Everyone should consider it, as no one cares more about our finances than ourselves.