Investing money in stocks has traditionally been one of the most popular ways to build wealth. It sounds tempting to put most of your investment money into the stock of a single top-performing company. But this can be a risky move because if that company's stock suddenly plummets, much of your investment portfolio plummets along with it.
Putting all of Your Eggs in One Basket
Putting too much money into a single stock is one of the Cardinal sins of personal finance. The prices of individual stocks can fluctuate wildly on any given day. Any number of factors can send a company's stock spiraling down quickly, including a major product recall, a disappointing financial report or a sudden loss of business. When this happens, you can lose much of your investment.
Temptation to Trade
When you have all of your money in one stock, you are likely to keep a close eye on that stock's performance. When it starts falling, you might be tempted to sell it quickly to prevent further losses. This can be a risky strategy because stocks often go through wide fluctuations on a daily basis. The next day or week, the stock you just sold could rise back up to its previous position or higher.
Taxes and Fees
A single stock portfolio can make it tempting to trade regularly, which can increase expenses like taxes and fees. Every time you place a stock trade, you have to pay a broker to make the trade on your behalf. In addition, any profit you make when you sell stock is subject to capital gains tax. The capital gains tax rate is equal to your income tax rate if you hold onto an investment for less than a year, so frequent trading can result in more taxation. It is preferable to hold an investment for a year or more, because after that the long-term capital gains tax rate is capped at 15 percent.
The reason financial advisers consider the stock market to be a good place to grow wealth is that the overall level of the market tends to trend upward over time. Buying and holding a single stock fails to capitalize on this basic principle: the value of a single stock does not necessarily follow the overall trend of the market. You can mitigate investment risk and take advantage of market trends by diversifying your holdings. Diversification means purchasing stock in many different companies so the value of your portfolio closely mirrors general stock market trends. Diversification limits the negative impact of picking a few bad investments.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.