Small investors have plenty of reason to feel skittish about the stock market. Stocks haven't been doing very well in the new millennium. Scandals involving Enron, Arthur Andersen and other companies make you doubt the veracity of corporate earnings statements investors use in picking individual stocks.
And the accusations of bias against some Merrill Lynch analysts make you wonder how many of these supposed watchdogs have turned traitor. Are analysts guarding the flock or guiding the wolves to the lambs?
Still, there must be plenty of good stocks out there. Short of bailing out of stocks, how can small investors protect themselves?
First, decide whether investing in individual stocks really makes sense for you, even if you didn't have all these trust issues.
With brilliance or luck, you might pick a stock that would make even the best mutual fund look like a dog. In a fund, run-of-the-mill stocks will hold back the overall gains even if the fund owns some superstars. Not so if you own individual stocks and they happen to be superstars.
With an individual stock, you also have total control over buy and sell decisions that can affect tax bills; with a stock fund, you can be at the mercy of the fund manager.
But if you pick wrong, your stock may turn worthless. In a fund, the stocks that do well will help offset the losers.
Put simply, individual stocks are a lot riskier than funds, though the returns can be higher for top-notch pickers.
Unless you have $200,000 to $300,000 invested in a well-diversified set of stock funds, it probably doesn't make sense to put any serious money into individual stocks.
To guard against catastrophe in a stock-only portfolio, you need diversification holding 10, 15, perhaps 20 or more stocks. Moreover, each purchase has to be big enough that the broker's minimum trading commission doesn't chew too deeply into your profits. Commissions will be especially big if you have a full-service broker make recommendations.
You could go it alone with a discount broker with cheap commissions. But suppose you had to closely examine 100 stocks to find 20 to buy? That's an awful lot of annual reports to read.
If you do want individual stocks and want someone to find them for you, how do you play it safe?
I, for one, would never do business with anyone I hadn't met face to face, and I wouldn't bother to meet anyone who'd contacted me with an unsolicited phone call especially if he said I had to buy now or lose my chance. I'd seek a referral from someone I trust, keeping in mind that people don't like to admit they've picked bad advisors.
Next, I'd check the backgrounds of the candidates and their firms. Find out whether either has been a target of disciplinary action by federal or state regulators.
Before picking a broker, have a long conversation with your final candidates. Find out how the broker finds stocks to recommend. Does the broker do his own research or is he just a salesman pitching stocks recommended by his firm? How will he decide what's good for you? How does he decide when to sell a stock that's gone up or down? How much experience does he have serving customers similar to you? Is his penchant for risk the same as yours? Will he help manage your portfolio with an eye to minimizing your tax bills?
Once you settle on a broker and he starts recommending stocks, probe his reasoning. Why is this stock better than a fund? Why is it better than other stocks in the same industry? What has to happen for the stock to do well, and what could undermine it? How big is the risk you could lose money? What kind of return does he expect? How long does he expect you to own this stock?
Ask whether he or his firm own the stock and whether they are buying more or cutting back. Does the firm have any conflicts of interest? Does it, for example, do any business with the company that issued the stock underwriting the sale of new shares, for instance?
Ask to see the reports by the firm's analysts not just the current ones but those going back awhile, so you can see how past predictions have panned out. Also ask to see any reports he has from analysts at other firms.
Finally, do some research. Many Web sites for investors have data, news reports and, often for a fee, analysts' reports from a variety of firms.
Sound expensive? Overwhelming? Time-consuming?
Then individual stocks probably aren't for you. Stick with mutual funds.