As the coronavirus pandemic took hold early this spring and markets plunged, a wave of Americans saw an opportunity to start investing. But one expert says this new herd is making some old mistakes — namely, chasing hot stocks.
"I'll say it: Individual stocks are terrible investments for people just starting out," Christine Benz, the director of personal finance for investment research firm Morningstar, recently posted on Twitter. “[W]e haven't talked enough about how poorly many small investors are apt to do with individual-stock purchases, especially if they're just learning.”
In an interview, Benz says she’s getting a sense of deja vu from the late 1990s, the rise of the dot-com bubble. "That, too, was a period where everyone was dabbling in individual stocks ... and it did not end well."
Free time and easy entry into the stock market
While tens of millions of people have seen their finances hit hard by the spread of COVID-19 and subsequent lockdowns, many others still have disposable income and, suddenly, more time on their hands. In the first quarter of 2020, some online brokerages reported a surge of new accounts: TD Ameritrade reported a 230% quarterly increase in new funded accounts during the three months that ended March 31; E*TRADE reported more than 360,000 new accounts for the same quarter, a company record. Both brokers also reported record daily average trade volume in March.
But it's not just circumstances that have fueled this wave of new investors into the markets. In recent years, online brokers and tech startups have introduced a range of new trading apps, push notifications and other features designed to entice young investors. Critics say some have gamified investing and made it too easy for inexperienced customers to access sophisticated and riskier financial instruments.
Another lure for new investors: free trading. Robinhood was among the first to offer free stock trades several years ago, and in late 2019, a number of big brokerages dropped commissions to $0.
A better first investment: Mutual funds or index funds
These trends worry Benz because active investing strategies, such as buying and selling individual stocks, often underperform against more passive approaches, such as index funds that simply follow a stock market index like the S&P 500.
"The data are not good for professional managers," Benz says. "These are highly paid, highly trained professionals, by and large, and they have not made a good case for themselves as a group."
If the odds are against the pros, amateurs can rarely expect to do better, Benz adds.
Benz isn’t against individual stocks — she’s since clarified that on Twitter, noting that her directive was primarily aimed at young college graduates investing for the first time. But the standard rule of thumb holds true: If you want to invest a small portion of your portfolio in individual stocks, be sure to invest the bulk in low-cost mutual funds or index funds.
Compared with a handful of stocks, funds provide instant diversification and decrease the risk of losing your investment.
"I think it makes sense for young folks to have more of a globally diversified equity portfolio," Benz says. "You can buy a total world stock index fund — one fund that gives you exposure to every economy on the planet, practically."
Another strong option would be a target-date fund, a type of fund that automatically adjusts its portfolio as you age. These funds give younger investors exposure to riskier investments that have higher growth potential first, then shift to more conservative investments over time.
"The virtue there is that could solely be the only fund you invest in until you retire," Benz says.
While chasing hot stocks may seem exciting, "unfortunately the key to financial success is incredibly mundane — it’s disciplined savings," she says. "Your savings rate is, by far, going to be the biggest determinant of how you do financially over time."