A QUESTION FOR YOU—a trick one, I admit: Should you invest in technology stocks, such as Apple?
My answer: Yes, certainly.
Another question, also a trick one: Should you invest in the stocks of entertainment companies like Netflix?
My answer: Again, yes, of course.
A third question: Should you invest in energy companies, such as ExxonMobil?
My answer: Again, yes.
You might wonder why I’m asking these questions and why I’m answering “yes” to all of them. Does that mean that technology, entertainment and energy companies are my favorites? Do I see an advantage that they hold over others?
No, I have no favorites—which is the topic I want to address here.
Folks will often ask me a question along the lines of one of my trick questions above: “Should I invest in…?” I am always cautious when answering. To be sure, each inquiry is grounded in observable facts: Smartphone usage continues to drive growth for Apple. Consumers love the original programming on Netflix. And a recovery in oil prices has enabled Exxon to shake off its four-year slump.
All of these things are true—right now. But you don’t have to go too far back to find a time when each of these companies was not the stock market’s golden child. Apple nearly went out of business before Steve Jobs came back. In 2011, a strategic blunder caused Netflix to lose 800,000 subscribers and 75% of its market value. And a 2014 decision by OPEC caused Exxon’s sales to get cut in half.
These aren’t anomalies; things like this happen all the time. In just the past few months, we’ve seen a tech company face a congressional inquiry, a drug company suffer a rejection from the FDA and a car maker contend with a fatal malfunction. In each case, the company saw its stock price dip. Companies frequently recover from such episodes. But in the midst of it, it can be awfully hard to know how things will pan out.
In recounting this history, I’m likely not telling you anything you don’t already know. But these stories carry an important lesson: We all understand the risks inherent in individual companies, and this unpredictability is the reason I don’t recommend buying individual stocks.
As an alternative, however, I sometimes see people opt for sector index funds, which own only companies from a given industry. For example, they might buy Vanguard Financials Index Fund, which offers a bundle of 422 financial stocks in one package, or Fidelity Real Estate Index Fund, which owns 104 real estate stocks. Because of the apparent diversification, and because the word “index” appears in the name, funds like this might appear to be good—and even safe—investments.
But I urge you to use caution. These funds carry significant risk. That risk may not be as obvious as the risk involved in buying individual stocks. But bear in mind that all of the companies in a given industry will be subject to the same external forces. Oil prices impact all energy companies, interest rates impact all banks, regulation impacts all health insurers, and so on. And when they strike, these forces will often impact all of the companies in that industry.
To be sure, the impact will not be evenly distributed. But the stocks will tend to move pretty much in unison. Result: The diversification benefit offered by a sector index fund may be far more limited than you assume. In short, while sector index funds are less risky than owning just one company from that sector, they aren’t a whole lot safer.
This is why I have no favorites and believe so strongly in owning total market index funds—those funds that own every company in every industry. While this may limit your potential gains, it will also limit your losses. I see that as a fair tradeoff.
Admittedly, even with a diversified portfolio, you can always count on the stock market to deliver moments of rollercoaster-like terror. But by avoiding overly concentrated bets on individual stocks and individual industries, you’ll be better placed to limit those unpleasant moments—and improve your odds of collecting healthy long-run gains.
Adam M. Grossman’s previous articles include Not My Thing, Nothing to Chance and In the Cards. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.