Eggs in a basketThis is the fourth article in a six-part series on investing for beginners, i.e., Investing 101.

One of the most serious risks in investing”particularly for new investors”is that because we have such small amounts of money to start with, we put it all in one place.

The Dangers of Individual Stock Picking

We’ll all been there: a friend gives us a tip that a particular company is hot, and it’s going to go up like a rocket very soon. Sometimes this is true: a friend told me about 4 years ago to buy stock in Marvel Entertainment (MVL) the comics company. He told me that the company held the rights to an enormous number of comic book characters, and was embarking on a very profitable series of Hollywood movies based on them. Would that I had listened! When I got this tip, Marvel was trading at $3.50 a share. Trading in Marvel stock closed yesterday at $26.75.

Stories like this one (a true story!) tempt us to follow the next hot tip. But the real lesson is the opposite. Sure, I would have made a killing on Marvel stock, but I would have lost money buying individual stocks in many other companies during that same time period, including Sony Corporation, owner of Sony Entertainment. I can’t tell a rumor from a hoax from a scam. Can you?

Individual stock picking is a very, very difficult game, and you will generally lose money. The fact is, if you put all your investments are in one area (one company, one industry, one geography, etc.), really really bad things can happen. Remember the Asian crisis of 1997? The internet bubble bursting in 2000? Enron and WorldCom? How about the housing bust in 2005?

Diversification

Don’t try to pick individual stocks. Diversify. This is just a fancy way of saying to spread your money around; don’t put your eggs all in one basket.

To give you an idea of what I mean. There are about 12 sectors in the U.S. economy, including very different enterprises from technology to healthcare to utilities. In early 2006 the energy sector (which is largely composed of oil companies) was booming, and we all felt it with $3/gallon gasoline at the pump. But lately the energy sector has fallen. Other sectors pulled ahead at the end of 2006.

Just like with the total stock market, it is practically impossible to predict which sectors will be hot in which years. Don’t bother. Again, I recommend index mutual funds. You can invest in all 12 sectors simultaneously with an S&P 500 index mutual fund, which diversifies you nicely–except that the S&P 500 is mostly large companies.

If you want even more diversification, try a “total U.S. stock market” mutual fund, like Vanguard’s. This way, your money is spread all over the place, including large and small companies, and while one sector may be underperforming, another is probably doing pretty well. (Sometimes all or nearly all sectors decline at once, say in a major recession or a very bad news day, but this is unusual and doesn’t last long.)

If you really feel passionate about some particular sector of the economy, and you really want to focus your money there, that’s ok (if you know what you’re doing). But you can still minimize your risk in two ways. (1) instead of buying individual company stocks, which is incredibly risky you can buy an index fund for that sector. For instance, if you really believe that the transportation sector is undervalued, and you want to buy stocks of many transportation companies at once, you can buy shares of a Transportation Index mutual fund. (2) If you are going to own sector index funds, balance them out with complementary funds in other sectors. So if you want to own a Transportation sector mutual fund, balance it out with index funds in Finance, Utilities, Consumer Cyclical, and/or Services.

Think global

So congratulations! You’ve saved up a little bit of investment money, bought yourself some low annual fee, no-load index funds in order to diversify, and you’re not itching to buy and sell all the time, saving a lot on transactions costs. You are becoming a savvy investor.

But are you savvy enough? What happens if the entire U.S. economy should go into recession for a while? Or, if the U.S. stock markets go up and down, as usual, but after 20 years they end up right where they are now?

Fear not. The U.S. stock market represents only 47% of the global stock market. If we diversify our investments internationally, we limit our exposure to risks in the U.S. We might also profit from the major economies in the rest of the world, like Europe and Japan. We might also realize a lot of gains as emerging economies develop, for instance the “BRIC” countries: Brazil, Russia, India and China, not to mention others that are not in the news as much. Perhaps Indonesia, with half a billion residents, will become a major world power. Who can say? But it would be excellent if our investment portfolio allowed us to profit from that possibility, without putting all of our eggs in that one basket, either.

Of course, investing internationally has its own set of risks: exchange rates between currencies; sometimes very different political, social, and religious environments that effect local economies; and the fact that it can be difficult to get good information on where to invest internationally. Taken together, these issues make international markets in general more volatile than U.S., meaning they go up and down more severely.

But the last few years, my personal international portfolio has been growing 20% to 30% annually, compared to my U.S. funds returning 10% to 12% a year. Lately, I sure have been pleased to own some international funds! But as we know, the global situation could change any time. In fact, between April and June 2006, stocks in developing countries took a big dive, and then recovered very strongly in the autumn. So we should avoid putting all our eggs in the international basket, too.

If you are interested to diversify your investments internationally (and you’re willing to accept the increased volatility in exchange for reducing your risk in holding only U.S. stocks), there are a number of good, low cost mutual funds to do this over the long term.

The cheapest I’m aware of is Vanguard’s Total International Stock Index Fund which represents basically the entire stock market of the world outside of the U.S. While international mutual funds often charge 2% or more in annual fees because of the increased complexity in running them, this Vanguard fund charges a measly 0.32% of your assets in annual fees.

Also relatively inexpensive is American Funds New Perspective which charges 0.74% in annual fees, and Julius Baer International Equity which charges 1.31%.

Buy and hold; diversify; think global. These three guidelines will help protect your assets through the many storms that are no doubt ahead.

The fifth article in this Investing 101 series will address one of the most sneaky threats of all: inflation, and how to beat it soundly.