This section provides a detailed framework for selecting mutual funds; however, this section only briefly discusses a framework for picking stocks. If you add individual stocks to your portfolio before it has become large enough to handle individual stocks, you are violating four of the principles of successful investing: stay diversified; invest low-cost; know what you are investing in; and don’t spend too much time, energy, and money trying to beat the market (unless you have a lot of time, energy, and money to spare). Purchasing individual stocks is not a required part of a successful portfolio.

1. Stay diversified: Buying individual stocks early in your investing career violates the principle of diversification. Investing in individual stocks is both the fastest way to become rich and the fastest way to become poor. Drawn by the potential for high returns, some investors treat the stock market like a lottery and invest a large percentage of their portfolio in a single investment. By doing this, these investors ignore the principle of diversification and significantly increase their risk.

The best way to build your portfolio is by wisely investing money in a variety of assets and asset classes each month (e.g., a diversified mutual fund)—not by putting a “bet” on a single stock. It is difficult to achieve an acceptable level of diversification in a small portfolio with a limited numbers of stocks.

2. Invest low-cost and tax-efficiently: When you have a small portfolio, investing in individual stocks is very expensive. Transaction costs for purchasing stocks are the highest of any major asset class. Also, many of the costs of individual stocks are charged separately from the amount purchased or sold. Costs for smaller purchases or sales are much higher as a percentage of the assets purchased or sold than costs for larger purchases or sales.

3. Know what you are investing in: Although several sections in this series discuss investing in stocks and specify the qualities of a good stock, you have not learned all that you need to know to successfully evaluate stocks for your portfolio. While buying individual stocks can be fun and exciting, it can also be a form of gambling if you do not have the necessary knowledge base. Your knowledge of stocks will grow with experience; the information on this website will not give you all of the tools necessary to make good stock-selection decisions, but it will give you a good foundation.

4. Don’t spend too much time, energy, and money trying to beat the market (unless you have a lot of time, energy, and money to spare): Trying to beat the market (i.e., earning a higher return than you could get on an index fund following your chosen benchmark) through purchasing individual stocks is a time-consuming and challenging activity. Expending great amounts of time and energy picking individual stocks violates the principle that you should not spend too much time trying to beat the market (alth. For most of you who are taking this course, you will be able to gain more substantial returns through wise investing and proper asset allocation than through spending a significant amount of time trying to beat the market with individual stocks.

5. Stock selection is not required for a successful portfolio: It can be fun and intellectually challenging to select individual stocks; however, your return will usually be greater and your risk will be reduced if you wisely select your asset allocation targets and use an index or other low-cost mutual fund to purchase a diversified portfolio of stocks. You can have a successful portfolio without ever having to buy an individual stock or sector fund.

Since analyzing companies is not likely going to be many of your jobs, it will be in most of your best interests to develop a “Sleep Well Portfolio”. This is done by writing and following your investment plan carefully (write it well and follow it), maintaining a generally passive strategy (indexing is a viable long-term strategy for most investors), enjoying your family and friends (make memories, not investment reports), and doing well in your day jobs (make a difference where you work).