3 Signs You Shouldnt Invest in Individual Stocks

SOURCE: FLICKR USER TAXCREDITS.NET

Stocks have historically provided investors with the greatest returns, but there are people for whom investing in stocks isn't the right choice. If you're deep into retirement or prone to worrying about the markets inevitable ups-and-downs, then owning individual stocks probably isn't the right decision. However, the desire to sleep well at night isn't the only reason why a person might be better off to shun stock-picking in favor of other investment options. Here are three other signs that stocks may not be right for your portfolio.

Selena Maranjian: One sign you shouldn't be parking money in stocks is if you are investing in companies without really understanding how they make their money. It's not enough to know that a company is in the cosmetics business, for example. You'll need to know how it makes profits doing that. Does it have its own stores, and are they typically in malls? Does it sell its wares mainly through other stores? Does it sell mainly online, or perhaps via a team of sales representatives knocking on doors and holding sampling sessions in homes? All of those different business models come with different implications.

Companies that sell through their own stores must maintain physical locations and staff them with employees. Those selling mostly online can be more profitable because they don't have to rent or buy locations and pay to keep the lights on and the employees selling. Think of the contrast between a brick-and-mortar clothing retailer, Amazon.com, and eBay. The clothing store has a lot of overhead expenses. Amazon has far fewer. It may sell clothes, but it does so through well-stocked distribution centers, shipping out packages to customers. eBay's business model is even "lighter," as it needn't even have warehouses and distribution centers. Instead, it lets various parties sell to and buy from each other, taking a cut of each transaction.

For another example, contrast Costco with other big retailers. Costco has a membership aspect to its business model that helps it keep its prices low by providing a significant and relatively reliable revenue stream from membership fees. Similarly, companies such as Netflix and gyms charge you monthly for access to their services.

There's more to know about the companies in which you invest, of course, but their business model is a great place to start, as it can help you spot strengths and weaknesses. The more you know about your investments, the better you'll likely do with them.

SOURCE:FLICKR USER DAVID GOEHRING

Sean Williams: One of the easiest ways to tell whether or not you're ready to be investing in stocks is to ask yourself one simple question:

"Do I have the ability to invest X amount of dollars into a stock, or series of stocks, and not touch it for three, five, or even 10 years?"

If the answer is no and you may need your investable cash in the near future (i.e., within the next three years), then you probably shouldn't be investing in the stock market.

The reason this is so critical is that real wealth is created not by trying to time the market over the short term, but by holding your winners over extended periods of time and allowing your investment thesis to go to work. It's virtually impossible to make smart investing decisions based on looking at how a company has performed over the past one or two quarters. You need to be able to look at years of its performance to understand how its business has transformed and where it's headed next.

Likewise, you can't expect an investment that you perceive to be inexpensive to turn on a dime. It takes time for innovation to work its magic on a company's bottom-line.

Additionally, investing for long periods of time is going to benefit you come tax time. Capital gains on assets, such as stocks, held for one year or less are taxed at a rate equal to your peak ordinary income tax rate. By contrast, the vast majority of investors will pay a capital gains tax rate of 0% or 15% (which one applies depends on their modified adjusted gross income) if they've held their investments for at least one year and a day.

If you don't have the time to watch your investment seeds bud into flowers, then you shouldn't be investing that cash into the stock market.

Todd Campbell: If you're just starting out investing or your investment account isn't big enough yet to allow you to diversify across many individual stocks and sectors, then focusing on other investment choices, such as mutual funds, ETFs, or bonds, may be your best bet.

Yes, it's tempting to roll the dice and put all your money into a sexy stock like Tesla, but doing so exposes you too much to Mr. Market's whims and whispers, and that kind of portfolio concentration can be an easy way to wind up in the poorhouse.

Therefore, until your account grows to levels that allow you to adequately diversify for yourself, consider targeting a low-cost total stock market ETF, rather than individual stocks. For example, Vanguard's Total Stock Market ETF owns more than 3,700 stocks (now that's diversification), and while past performance doesn't guarantee future performance, it has produced an average annual return of 5.9% since 2001.

The article 3 Signs You Shouldnt Invest in Individual Stocks originally appeared on Fool.com.

Sean Williams has no position in any stocks mentioned. Selena Maranjian owns shares of Amazon.com, Costco Wholesale, eBay, and Netflix. Todd Campbell owns shares of Amazon.com. The Motley Fool owns shares of and recommends Amazon.com, Costco Wholesale, eBay, Netflix, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.