Individual stocks can have unlimited upside and don't come with management fees. So are they a good bet for your 401(k)? Here's how you can decide whether stocks are right for your 401(k) and limit the risks associated with them.
Please note: This article assumes that your 401(k) comes with the option to invest in individual stocks, but many plans do not.
There's no question that investing in individual companies can grant your retirement account returns that even the market can't touch. Warren Buffet has made a career of picking companies to invest in, and you might be tempted to do the same within the tax-deferred auspices of your 401(k).
But should you?
The main challenge of stock-picking is, well, picking stocks. To be successful requires nerve, research, and extraordinary patience. Do you enjoy analyzing individual companies? Do you have the patience and risk tolerance for it?
Choosing poorly, following hot fads, and trading excessively can slowly but surely cause a great deal of damage to your portfolio. While we all like to believe that we're above average at things, the sad fact is that most of us aren't. Overconfidence about your abilities can put significant drag on your retirement portfolio. A seminal study on the subject found that high-trading households didn't outperform infrequent traders, fees not included, and they performed about 7% worse, on average, with fees taken into account. Compound that over 30 years and you could be losing a significant amount of money just by racking up transaction fees.
If you can choose critically and stand by your choices, you can add potential upside to your 401(k), especially given its tax-deferred status. But if you have a tendency to chase fads and rotate in and out of positions, you'll probably do more harm than good.
Limit the potential damage
One strategy for stock investing in your retirement account is to give yourself enough rope to have fun, but not enough to hang yourself with. You might impose some rules about how much of your portfolio can be in stocks, or how much you're allowed to invest in a particular company. Having these kinds of boundaries can help prevent too much risk from creeping into your portfolio.
This process is critical -- especially for something as important as retirement. While your S&P 500 index fund can lose a lot of money at a time, it's not in and of itself going to go bankrupt. Eventually, it will climb back up, which is the whole point of a long-term investment outlook (and low-cost index funds).
An individual stock, on the other hand, can go bankrupt, leaving you with nothing. So, how much you can stand to lose outright? Is it 5% of your portfolio? Maybe 10%? Similarly, putting a limit on the concentration of a single stock can help mitigate some of the risk that comes with investing in equities.
Of course, a rule is only as good as its implementation: You need to remain strict about sticking to such rules, otherwise they won't help you.
Stay aware of expenses
While individual stocks don't have expense ratios, they do come with expenses. First is the potential fee for establishing a brokerage option in your 401(k). Depending on your asset base and your passion for stock investing, it might be nominal, or it might give you pause -- either way, you should know what it is.
Secondly, and significantly, you will encounter transaction fees. Again, there is no better way to lock in losses and chip away at gains than trading too much, so make a plan for your investment strategy and stick with it. Perhaps you'll want to rebalance once every year or two.
But if you find yourself tinkering quite often, you may want to do a quick back-of-the-envelope calculation on how much you're spending on trades versus the performance you've enjoyed as a result of that trading. You may find that frequent trading really does depress your returns.
Consider the role of company stock
Many large companies offer their employees the option to invest in company stock. But as Enron employees discovered, holding a large amount of company stock is not always a good idea.
If you have company stock in your account, take a hard look at your exposure. Considering that your paychecks are already tied to your company's performance, having too much of your retirement tied up with it as well could bring too much risk.
This is also an issue with respect to your other stock holdings. If you already have company stock in your portfolio, consider diversifying away from that industry or sector. You may be good at judging your company's competitors, but if the whole industry gets into trouble, that knowledge won't be worth much.
Investing in individual stocks can be a low-cost way to add big upside to your portfolio if you limit risk, focus on the long term, and avoid overtrading. Just be sure to go in with your eyes open!