Problems with Owning Individual Stocks and Index Funds at the Same Time

When you begin your journey towards financial independence you can’t imagine some of the problems along the way. Investing starts out larger than life and scary until you see how simple index funds make investing in large successful companies is.

Before long you have a large nest egg in your 401(k) and IRAs. Eventually your savings rate starts building your non-qualified accounts (non-retirement) as well.

As your net worth reaches for the sky you have the latitude to try some alternative investing in a mad money account. You start reading books on super investors like Warren Buffet and Ben Graham and decide it is worth learning the process of buying outperforming individual stocks with a small portion of your portfolio. Besides, you might really have a feel for finding great underpriced companies to buy stock in.

Bad Choices

As you search for a diamond in the rough you give no consideration to your index fund investments. They always chug along with the market without any effort on your part. All automatic. Set it and forget it. But you are about to blow your portfolio out of the water without realizing it.

The tendency is to buy winners. Apple Inc. is at the top of the pile and is the largest market capitalization stock in the S&P as I write, which means you own more Apple in your S&P index fund than any other company. They have winning products and lots of cash to weather any storm so it sounds like a good investment. Heck, they just released a new phone for a cool thousand bucks! How can you go wrong? Good thing the index fund loaded up for you.

Index funds invest more in the winners by default. The bigger the company the larger the market capitalization (determined by the stock price and the number of shares outstanding) and index funds buy based on market cap. Therefore, since Apple has the largest market cap, the S&P index funds hold the most of it. The index fund’s next largest holding has the second largest market cap and so on.

As long as you are buying individual stocks you may as well diversify a bit. Facebook is a household name with plenty of prospects. Facebook, Class A stock is number three in the S&P 500 weighting list. Amazon is another highflyer at number four.

These winners are virtual no-brainers. It’s like shooting fish in a barrel. Warren Buffet isn’t so great after all. Your short list of winning stocks is on a roll.

Here is the current weighting of each company in the S&P 500. The list changes as the component’s prices change in relation to each other. Today’s top dog is not yesterday’s top dog.

Today’s king is dethroned without fanfare. Today Apple tops the list, unseating Microsoft. Someday Apple will be unseated, maybe by Amazon, who knows? If you look back in ten year chunks you will notice the top stock by market capitalization always changes! Eventually fallen kings leave the top ten list and some fall even further. General Electric and Wal-Mart are showing us how this is done live.

Portfolio Bloat

So what does this have to do with buying individual stocks when you also own index funds?

When you own an index fund you still really own a pro-rata share of the underlying securities in the fund. It doesn’t always feel that way, but when you own the S&P 500 index fund at Vanguard you actually own a slice of 500 companies!

Let’s go back to Apple. Apple is the highest weighted stock in the index at 3.948665 as I write. This means if I have a million dollars invested in the S&P 500 index fund I effectively own $39,486.65 of Apple stock!

If you don’t like the high price of Warren Buffett’s company, Berkshire Hathaway, don’t worry. As the sixth heaviest weighted stock in the index you own $15,824.96 of Berkshire through the index fund for every million dollars of index fund investment.

Then we get to the bottom of the list with News Corp, Class B. Your million dollar index fund investment grants you an effective ownership of $69.85 of News Corp, Class B.

Astute readers will have already noticed the problem. If you buy more of the winners, you are overweighting and already overweighed investment! You already have over 3.9% of your portfolio in Apple. We also know Apple may continue to rise for a very long time. But the record is clear; the top dog never stays on top for long.

Buying more Apple when history says Apple will not stay on top forever—even another decade most likely—means other companies will grow faster! Adding too many additional shares of individual companies already at or near the top of the index weighting leads to portfolio bloat.

As these winners keep pace you will be a very happy investor, but when it goes south it will create an overweighting of drag on your overall portfolio. Apple’s stock price affects the index fund the most and if you also own Apple individually as well, Apple will cause outsized moves in your portfolio. The real question is: Do you want to own more Apple if you already own more Apple than any other company through your index fund investments? You need to make the call.

Total market index funds run the same risk. All index funds will have a weighting of how much to own of each company. It would be impossible to own an equal share of the smallest firm as the largest. Bigger companies are therefore more important inside the index fund.

Buying a smaller company’s stock may therefore compliment your index fund as the smaller company could be on the rise as it heads to the top.

The Antacid for Bloat

Don’t be glum. You can have your cake and eat it too.

I bought my first shares of Phillip Morris (MO), now called Altria, back in 1984. Morris has been steady near the top of the list so it kept pace with the leaders while throwing off a massive and growing dividend I managed to reinvest in more MO stock.

If my count is correct, MO is number 40 on the current list, down from the top ten years ago. But. . . , MO did something in the mean time. It spun off Phillip Morris International (PM) several years ago and PM is the current number 23! The spinoff is bigger than the original firm! And both pay dividends like manna from God! (Yes, that is a lot of exclamation points. I made a lot of money from my MO investments over the years.)

MO isn’t part of my mad money account. It is part of an old DRIP (dividend reinvestment plan) portfolio I held in trust. There were twelve total stocks in the original DRIP portfolio. Only AFL and MO remain as memory serves. (Don’t trust an old farm boy’s memory too much. I didn’t double check to verify since it’s irrelevant to the story.)

Coke (KO), GE, ITW, JNJ, Hershey (HSY) and Paychex (PAYX) were some of the companies in my original DRIP portfolio. The one that bothers me most is Wrigley’s (WWY). My good buddy, Warren Buffet, funded Mars, Incorporated so Mars could pay cash to buy out WWY. Mars is a private firm so I received cash only and no stock in the new company. Bye-bye dividends and free case of gum every Christmas. (grumble, grumble) My kids still cry over that one. They also held Wrigley’s. Darn Buffett.

Many of these companies did well after I sold. I just wanted to consolidate. The index fund gave me diversification. My individual company investments needed to complement the index fund. I am not interested in top-heavy investing.

The best cure for portfolio bloat is to search for gems down the list or even from smaller companies not on your broad-based index fund’s list. The odds are better a company not at or near the top will outperform the index itself. And if you have no chance of outperforming the index fund (a tall order in and of itself), then why bother. Stick with the index and do something else with your time.

Finding Winners

The tricky part is knowing which companies will move up the list (performing better than the index’s average). The top market capitalization companies on the list can and frequently do rather well. But for your individual stock investments to do better than the index you need to buy companies which are moving up the list or if you buy the top dog, the top dog needs to keep expanding its distance from the rest of the pack.

The law of large numbers makes this harder and harder as time goes on. Getting on top is really hard; staying there a really long time is near impossible. In fact, nobody has done it for decades at a time. GE and KO and MO have been perennially at or near the top. But unless the company also throws a massive and growing dividend and still remains on top you will find buying these stocks on your own doesn’t help performance, it hurts it.

This post doesn’t have room to discuss how to find a quality company down the index list.

If you feel up to the task and have done your research, you can invest a small portion of your portfolio on your own. For most people the index will do better on its own without your help.

Of course, you can buy Apple because it is such a hot stock and awesome company. They could stay on top forever. This time could be different.

Or maybe not.