Many of us recommend low cost index funds for the individual investor. Some of the articles provide a good argument, while some don’t even give a reason at all. This article illustrates what happened with one of my reader’s investment portfolio so we can judge for ourselves whether low cost index funds are for us.
Like you, I am in the west coast and when I get to the office, the US stock market already opened. Sometimes I check the performance of my stocks, and other times I do not (actually, I check it all the time). When I did check it this morning, I noticed that the money in my taxable account went down by 12%. I looked into the details and realized what happened. One of my stocks Wavecom (WVCM) just reported earnings and the stock went down 20%. Since I had a ton of money in this stock, I was hurt bad. Really bad. Panicking, I sold WVCM along with Apple (AAPL) because I was afraid Apple was going to report bad earnings too. I’m really pissed off right now because I checked after hours and Apple is up more than 10% since I sold it. I realized I was being dumb and really want to see if you can recommend some low cost index funds for me to own since I am clearly not cut out for stock picking.
His story is all too familiar. I remember making similar mistakes in the stock market when I first started investing because I too panicked when a stock didn’t go the way I thought it would. The beginning of my investment career were filled with moments of me selling low and buying high because when stocks go down, I will sell and then when they go up, I will buy them again think I will miss the boat. Over time, I managed to learn from my mistakes but the lessons were very costly.
When stocks go down significantly, some of us almost get this sickening feeling in our stomach. Sure, any individual stock could go up significantly and boost our portfolio’s performance, but the risk is also very high.
Some people who pick individual stocks don’t even know much about the company. In essence, many of these people are treating the stock market like a casino. Furthermore, many of us don’t have the tolerance to properly manage the emotional roller coaster of individual stock prices going up and down. We end up buying high, and selling low because of our greed and fear.
Everyone who have individual stocks in their portfolio should examine their risk tolerance not when times are good (when stock prices are soaring) but when times are bad (the day the price drop significantly). Only in adversity can we truly determine our risk tolerance.
Low cost index funds on the other hand are much less volatile. No one will become rich overnight, but it is a much more dependable way to investing in equities. It gives us comfort that our portfolio would not get crushed if something horrible happens to any particular company (e.g. Enron), and will help us better see the long term benefits of investing in the stock market.