How to pick stocks: Don't buy just one

By Walter Updegrave, senior editor


(Money Magazine) -- Question: I'm a recent college grad with a steady job. Now that I've saved some money I want to invest. I've opened an online brokerage account, but the problem is I have no idea how to pick a stock. Where do I start? -- Celia, New York, N.Y.

Answer: There's actually a very simple solution for anyone who wants to invest in equities, but doesn't have the foggiest idea of how to pick even a single stock.

walter_updegrave__2009b.03.jpg
Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Don't buy one stock. Buy a few thousand.

Yes, I realize that on the face of it, that may seem absurd. If you're that unsure of your stock-picking prowess, wouldn't buying hundreds or even thousands of stocks be much dicier than trying to settle on just one good one?

The answer, paradoxically enough, is no. You're actually taking less risk by buying in bulk, provided you go about it the right way.

Here's why.

When you invest in stocks, you are taking on several types of risk. Two of the most important are called systematic risk and idiosyncratic risk.

Systematic risk is simply the risk of being in the stock market. Every stock's price fluctuates with the market overall, to one degree or another.

To see the extent to which a stock will likely rise more steeply when the market soars or fall more sharply when it drops, you can check out a stat known as beta which you can find by plugging a stock's name or ticker symbol into the Get Quotes box at Yahoo! Finance and then clicking on the Key Statistics link under the Company heading on the quote summary page.

The second risk is called idiosyncratic, or specific stock risk. This is the possibility that you'll incur a loss not just because the stock market declines, but that something goes wrong with the particular stock you've chosen. Maybe the new product that's supposed to boost earnings falls flat. Or perhaps an audit reveals that a top exec has been pilfering company funds to finance a lavish lifestyle.

The important point, though, is that while you can't get away from systematic risk -- any stock you own will always be tied to the fortunes of the market overall -- you can sidestep much of the idiosyncratic or specific stock risk. How? By diversifying.

If you plow all your money into just one stock and the company suits make a series of blunders that sends the firm into bankruptcy, your entire investment stake is in jeopardy. But if you spread your money among many stocks, you dramatically reduce the chances of taking a big hit due to idiosyncratic risk. After all, if you own, say, a couple hundred or more stocks, what are the chances that the management teams of all of them will screw up?

In short, when it comes to buying stocks, there is at least some protection in numbers.

So how do you get that protection as well as a shot at the long-term investment growth stocks can provide?

Well, I say the easiest and most effective way is to invest in a total stock market index fund. When you buy this type of fund, you are effectively getting the entire U.S. stock market in a single fund. That means large, medium and small companies in all industries and sectors of the market the whole enchilada.

What's more, you can get all this at a relative bargain price. The annual operating expenses on such funds are typically less than 0.20% of your account value each year, and can even run as low as 0.07%. That's $7 to $20 a year on a $10,000 investment.

You can find a total stock market index fund in our MONEY 70 list of recommended funds, although other versions of this type of fund are also available through most large investment firms. You can also buy a total stock market fund as an ETF, or exchange traded fund. Until recently, a downside to ETFs was that brokerage commissions could erode the low annual expense advantage if you're investing small amounts. But a number of firms, including Fidelity, Schwab, Vanguard and TD Ameritrade now offer ETFs without the brokerage commissions (although you should still see if there are other fees or account minimums).

Before you boot up your computer to invest in a total stock market fund or ETF, however, I have two caveats.

First, when you start scouting around the index and ETF world, you'll quickly find that investment firms also tout a mind-numbing array of variations on the total stock market theme, splicing and dicing the market into hundreds of indexes and ETFs focused on sectors, subsectors, market niches and, in my opinion, just plain gimmicky products.

As I've noted before, I think investors are better off ignoring such gewgaws, as well as the explicit or implicit idea that you can boost returns by deftly timing your moves in and out of ETFs focusing on particular sectors. Focus instead on investing for the long-term in a broad portfolio such as a total stock index fund.

Second, since buying a total stock index fund still leaves you vulnerable to systematic or market risk, I suggest you mitigate that threat a bit by putting some of your investment stash into another asset class -- bonds. You can take the same approach as with stocks by buying a total bond market index fund or ETF. (For guidance on how much to devote to bonds, click here and here.

If you still want to try your hand at buying individual stocks, fine. You can learn more about how to do that by checking out our MONEY 101 lesson on investing in stocks and by going to the Stock Investing Courses link under the Learn heading in the Stocks section of Morningstar.com.

But I suggest you wait until you've already established a core portfolio using the approach I've suggested here, and then go slow with modest amounts of money. Otherwise, learning about the stock market could be one of the most expensive educations you'll ever get.

-- An earlier version of this article incorrectly referred to TD Ameritrade by its pre-merger name, TD Waterhouse.  To top of page

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