Experts say some stock investors could be at risk of getting burned. How to make sure you're not one of them
- Name stocks such as Tesla, Apple and Microsoft were popular with investors in 2020.
- But individual investors should be wary of overconcentration in single stock picks.
- As some experts see echoes of the dot com bust, these tips can help you stay diversified.
As some stocks have climbed to record highs, you may have been tempted to double down on a favorite pick, like Tesla or the latest initial public offering.
But at least one money expert is sounding the alarm that some investors may be overexposed to individual stocks.
Christine Benz, director of personal finance at Morningstar, said she vowed to speak up the next time she saw potentially dangerous market conditions crop up, after the dot-com bust of the late 90s.
"It feels like that time is here," she tweeted last week.
More from Personal Finance:
Here's a decade-by-decade retirement planning guide
State, local tax breaks could be revived, but not without a fight
Savings interest rates hit rock bottom as Americans stash more cash
A sudden pullback on stocks could result in a "painful outcome" for some investors, Benz said, specifically for those who are approaching retirement and have lost sight of the amount of risk they have taken on.
Investing in stocks is an uncertain bet, even for experts.
In the past year, the contrast between what is going on with market and in the world at large has seemingly grown bigger. As the Covid-19 pandemic prompted a sharp economic downturn, record unemployment and 400,000 deaths in the U.S., stocks soared.
Many Americans raised their stakes in companies, particularly names they know. In 2020, the five most popular stocks bought by TD Ameritrade clients included Apple, Microsoft, Tesla, Pfizer and Boeing.
For investors, the market environment has been "a bit of a two-edged sword," according to JJ Kinahan, chief market strategist at TD Ameritrade.
"You have to be careful, especially when we're at all-time highs," Kinahan said. "But if you've been playing the buy every dip game for the last few years, your success has been in many ways unparalleled."
Why investors could get burned
The allure of those potential wins has attracted people who have more time and money on their hands during the Covid-19 pandemic, according to Benz.
What's more, there's a peer pressure factor that's making some people feel like they don't want to miss out, she said.
"That excitement often crests when valuations are high," Benz said.
Take Tesla, for example. On Wednesday, the stock was trading at almost $850 per share. But Morningstar believes its fair value is slightly over $300 per share.
Like the days of the internet boom, there are some exciting stories that are driving interest in individual companies, Benz said. But just because a stock has gone up 700% doesn't mean another 700% gain is coming, she said.
It's not exactly a replay of the stock fervor of the 90s, however the high-stakes risks are similar.
"In this sort of environment, this is when we do tend to see some of the newer, inexperienced investors get burned," Benz said.
Be wary of risks you can't see
Some investors may be building portfolios that exclusively include Tesla-like names.
"That is where I believe investors can get in trouble," said David W. Karp, co-founder of PagnatoKarp Cresset.
Amazon is one company to have survived the dot-com bust. But the stock has always been highly priced, even in 1997 when it was trading at "outrageous multiples of revenue," Karp said.
Cisco Systems, another example from that era, has seen its revenue and earnings surge since that time, though its stock price did not.
"The business grew into the valuation, but the valuation just didn't continue to expand," Karp said.
The examples highlight one investing truth: "There are plenty of great businesses that may not be great stocks," Karp said.
It's OK to own some of these company names, Karp said he tells clients.
But make sure you ask yourself some key questions: What am I buying? What am I investing in? What is my dollar purchasing for me?
Right-size your bets
One way to prevent big losses is to limit how much risk you take on in the first place.
"If you want to use individual stocks, think of them as a Mad Money portfolio," Benz said. "But use your real money for a serious and diversified, well-balanced portfolio."
Mutual funds or exchange-traded funds with broader exposure to multiple stocks can help, particularly with regard to long-term goals like retirement.
It's also important to watch for ways overexposure may happen.
Investor portfolios tend to get out of balance in two scenarios, according to Kinahan — when one stock does really well and outperforms, or when a newer investor does not have enough capital yet to diversify.
One way to avoid regrets is to take a cautious approach.
For example, as new companies tap the public markets, an IPO might not perform as well as expected, Kinahan said.
"You don't have to invest on day one," Kinahan said. "If it's a good company, you're going to have plenty of opportunity."
Also brush up as much as you can on a company or fund before you invest. At TD Ameritrade, use of the firm's education tools was up three times in 2020 versus the year before. And there is always room for people to become more educated, Kinahan said.
"I would like to see people do that, especially those who are newer," he said.