So my father and I have this ongoing debate. I keep trying to get him to invest in more mutual funds but he enjoys the thrill of buying and selling individual stocks too much. Watching the stocks tick up and down is an adrenaline rush for him.

Am I up?!

Am I down?!@$%

So I thought writing out my reasoning might benefit both him and you as well.

Reasons to avoid individual stock purchases

Here’s a short, non-comprehensive list of reasons why you should not make individual stock purchases.

1. You are probably not an analyst – Analysts and brokers make money by studying companies and market trends day in and day out. Your day job probably does not allow you to invest the necessary time to  properly research a given company.
2. It’s easy to fall prey to “hot stocks” – If a buddy or Jim Cramer tells you about a rising stock, then most of the growth has probably already occurred. Meaning, individual investors often jump in at or near the peak.
3. Transaction fees and taxes – I’ve invested in individual stocks. So I’ve been in and out of stocks and I’ve seen transaction fees (even the low $7 price from Scottrade) and taxes eat away at profits. What my Dad has ignored is the fact that if he doesn’t hold the stock for at least one year, then the profits are taxed at his tax rate instead of the preferred capital gains tax rate. That’s been a pretty big spread for some people. Unfortunately, the lower capital gains tax rate is set to revert to a higher rate next year if Congress doesn’t change the law. So write your representative.

Reasons to buy Mutual Funds or ETFs

For most investor, mutual funds or ETFs are a good financial fit. Here are a few reasons why.

1. Sleep easy portfolio – I had a Financial Planning professor who taught this principle. A sleep easy portfolio is a portfolio that doesn’t keep you up at night. You have a solid, well-diversified portfolio that can take hits now and then.
2. Low transaction fees – If you want to invest through an automatic investment plan, then buy mutual funds direct from the fund family. If you are investing in no-load funds, then you have no transaction fees. If you are making a one time investment, then an ETF may be better since the management fees are lower than with mutual funds. So even though you incur a transaction fee, the lifetime costs are lower.
3. Diversification – I know that you’ve been told that you need to diversify at least 100 times. And if the market over the last two years hasn’t taught you yet that you really need to diversify, then divest and head to Vegas; your odds are about the same.

If you must invest in stocks

I have two pieces of advice for all of you who just can’t help yourselves. First, wait until your total investment portfolio reaches at least $500,000. Second, never invest more than 5% of your investment portfolio in individual stocks and never more than 2.5% in a given stock. If you follow these two guidelines, then you avoid over-exposing yourself to company specific risk.

On a side note, having a portfolio with a mix of asset classes helps reduce your market risk. So not only should you invest in funds and ETFs, but you should diversify through a variety of asset classes. I personally like this asset allocation calculator.

I was happy to receive a short email from my father recently. He simply stated, “How do I get into the S&P Index Fund? Should I?” Good things do come to those who wait.

Any other important guidelines that I may have missed? For more commentary and information, sign-up for our RSS Feed using your favorite reader.