Investing in individual stocks is the most common way for investors to build a portfolio. However individual stocks are inherently risky to hold for a variety of reasons. Some of the risks with holding stocks include:

• There is no guarantee that a would an investors would go up. It is perfectly possible for any stock to go down or an investor to hold that stock for many years with flat or even negative returns.
• Dividends paid by a firm on its common stock can be suspended or cut any time for any reason. Dividends are completely discretionary and a company can decide to eliminate it for whatever reason. Since ordinary investors do not have a say in how companies are run they are at the mercy of the CEO and the board running the firm on a daily basis.
• Investors do not have all the information of a company’s inner workings. For example, despite quarterly reports and other reports filed by firms, not all the information is widely and publicly shared. So if a massive fraud is going on with accounting inside a company investors will be in dark until it unravels publicly. Only a handful of people in the firm would have knowledge about such things.
• Another reason individual stocks are risky is that though the whole market may go up the stock one holds may not necessarily go up. So one holds a portfolio of such stocks they will be out of luck.

The following chart from a recent journal article shows this phenomenon:

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Source: The Trap of Trying to Pick Individual Stocks, by Liam Pleven, Apr 3, 2015, WSJ

From the WSJ article:

Investors could be easily dazzled by the current stars of the stock market and tempted to ditch boring index funds for a piece of the action.

Twitter shares have gained 41% this year through Thursday. Apple is up 14%, after rising for six years in a row. Shares of Kraft Foods Group have shot up 45% since March 24, the day before a proposed merger with H.J. Heinz was announced.

Not bad in a year when the S&P 500 is up less than 1%.

But consider this sobering fact: Even when the market is up, many stocks drop. Last year, when the S&P was up 11%, 125 stocks in the index fell, says S&P Dow Jones Indices.

As the example shows above, diversification is very important when building a portfolio of equities.  The following is another example that shows the importance of diversification.

The S&P 500 fell by 37% in 2008 during the global financial crisis of 2008-2009. But even during that time there were some stocks that actually went up while many stock plunged with some falling over 90% or disappearing altogether.

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Source: The aristocratic investor (and Downton Abbey spoilers) by Andy Clarke, Vanguard Blog

In summary, the key to successful investing in equities is to select and build a portfolio of high-quality stocks and hold them for the long-term.It is never a wise idea to put all the eggs in one basket.

Disclosure: No Positions

Biotech stocks are hot again this year as investors hope for spectacular gains like last year. In 2014, biotech stocks returned more than 34%. While the NASDAQ is up by 7.5% year-to-date (YTD) the NYSE Arca Biotech Index has shot up by 19.2% YTD.

The following chart shows the 10-year price return of the largest biotech ETF – iShares Nasdaq Biotechnology (IBB):

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Source: iShares

The chart shows that biotechs have taken off like a rocket since 2011 and there seems to be no signs of slowing down.

Though biotech stocks are on an upward trend caution is needed for investors looking to commit new capital to this sector. Here are some of the reasons to be cautious about this sector from an article by Tom Stevenson of Fidelity,  UK:

• The graph below shows the MSCI Biotech Index thru late March this year. This chart looks almost similar to the NASDAQ 15 years ago. Biotech stocks have shot up six-fold in the past ten years.

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• Many start-ups with no revenues or profits are bid up since no-one knows what they are worth.
• About three-quarters of companies in the NASDAQ biotech index have no profits.
• Just five firms account for more than 80% of the sector’s earnings.
• Much of the biotech rally is momentum-driven and unsupported by fundamentals.

Source: Beware the temptation of the biotech bubble,  Mar 31, 2015, Tom Stevenson, Fidelity,  UK

Some of the largest biotechs by market cap include Amgen Inc. (AMGN), Gilead Sciences Inc. (GILD), Biogen Inc. (BIIB), Celgene Corporation (CELG) and Regeneron Pharmaceuticals, Inc. (REGN).

Nearly 150 biotech companies trade on the NASDAQ with 148 firms included in the The NASDAQ Biotechnology Index. The complete list of biotechs traded on the exchange can be found here. As discussed above, many of these firms are highly risky for long-term investments. The table below shows some of the worst-performing biotech stocks in 2014:

Source: The Worst-Performing Biotech Stocks Of 2014, Forbes

The stocks shown above plunged between a shocking 72% to 93% in just one year. So before investors dive into biotechs they have to be highly selective and allocate only a very small portion of their assets to this sector at current levels, if they decide to invest. Ideally one may want to wait and watch if this rally can hold and stock prices come to sane levels based on fundamentals.

Disclosure; No Positions