Why Passive Investors Should Become Stock Pickers

When I started investing 20 years ago, I was terrified of the idea of investing in individual stocks. My parents never taught me about the stock market, and all that I knew was what I read in books. So when I started investing, I invested in stock and bond mutual funds.

I did so poorly at first. An "advisor" at a local bank with a brokerage arm steered me into a few expensive mutual funds with front loads (fees you pay just for the privilege of giving a mutual fund your money). The funds were actively managed, not index funds. That meant that on top of the front load, I was also paying a lot in fees each year so that a manager could pick stocks the fund would buy. The fund never beat the S&P 500. So basically, I paid a mutual fund a ton of money to underperform the market.

It didn’t take long for me to conclude something was very wrong with this picture. With the help of some great books, like Rick Ferri’s All About Asset Allocation, I concluded that passive investing was the best way for me to build wealth in the stock market. This lead me to a fanatical attack on fees and managed funds. I moved most of my money to low-cost index funds. You can read about my views on mutual fund fees, the hidden costs of mutual funds, and how costs can eat away at your retirement.

As I learned more about the market, I eventually concluded that picking individual stocks was like chasing fool’s gold. You may be able to beat the market for a time, but like the great Bill Miller (whose Legg Mason fund beat the S&P 500 for about 10 years and then cratered), eventually your luck will run out. So I stuck with mutual funds, most of them index funds.

Today, my perspective has changed significantly. While most of my investments are still in low-cost mutual funds, over the past two years I’ve started investing a portion of our money in either individual stocks or industry-specific ETFs. There are two big reasons why I’ve taken this approach, which I’ll discuss in a moment. But first, let’s talk about passive investing.

What is passive investing?

Passive investing is about a lot more than index funds. In fact, I'd argue that passive investing is less about what you invest in than how you invest.

For example, I know plenty of people who invest all of their portfolio in low-cost index funds. So far, so good. But when a bear market comes along, they sell their index funds and stash their money in bond funds because it makes them feel safer. When the market is going up, they do the opposite. This is not passive investing.

On the contrary, I'd argue that you can be a passive investor by picking a single stock and sticking with it through good times and bad. You'd have to pick the right stock in a company that is very diversified, like Berkshire Hathaway. But to me, such an investor would be far more passive than one who jumps in and out of index funds as the market rises and falls.

Learn More: Best Investments for Passive Income

Why individual stocks have a place in a passive investor’s portfolio

As I’ve had more experience investing and now manage a much larger portfolio than I did 20 years ago, my views on investing have changed. Today I own stock in several companies (Apple, Cisco, Citi, Verizon, Pepsi, Berkshire) and an industry-specific ETF (ITB-Housing). I’ve made this move for two reasons.

First, in taxable accounts, you have far more control over capital gains with individual stocks than you do mutual funds. Unless I sell some of my investments, I pay no capital gains tax. While you can invest in tax-efficient mutual funds, you still don’t get the same level of control. The same is true for dividends.

If you have $10,000 to invest, the tax issue may not matter to you right now. But as your portfolio grows to 6 and even 7 figures, taxes will become huge. And that’s particularly true if you are in one of the top tax brackets.

Second, it’s cheaper to invest in individual stocks than it is to invest in mutual funds or ETFs. With ETFs and index funds, you can find some really inexpensive ways to invest. Vanguard’s S&P 500 fund, for example, costs just 5 basis points a year (just $5 for every $10,000 invested). But every dollar counts, and with individual stocks, there are no mutual fund management costs. You do have to pay a brokerage fee when you buy the shares, but the best online discount brokers cost just a few dollars per trade.

In my case, I’ve been able to lower my overall expense ratio from 48 basis points to just 28. Twenty basis points (.20%) may not seem like a lot, but over a lifetime of investing those costs add up to a significant amount.

But what about diversification?

I was nervous when I first started investing in individual stocks. But over time I’ve come to really enjoy it. I still have the vast majority of my money in low-cost mutual funds and ETFs. But the portion I have in individual stocks has become an important part of our investment plan. Our costs are down, and our taxes are down.

All of that being said, investing in individual stocks is not for everybody. For beginners, I’d stick with low-cost mutual funds, ETFs, or something like Betterment (an excellent option that has really come down in price).

If you’re a passive investor who still buys individual stocks, leave a comment to let us know why you’ve taken that approach and how you’re doing. If you think buying individual stocks is a big mistake, we’d like to hear from you, too!