It's finally happened. The risks could outweigh the rewards when it comes to individual investors investing directly in the stock market. Whether it's due to a creeping contagion of toxic debt, or what CNBC's Mad Money guru Jim Cramer calls "hedge fund managers gone wild," there are forces at work impacting stock prices that have nothing to do with a stock's fundamental value.
As Cramer explained it, hedge fund managers are in control of the stock market and they are causing all this volatility and erratic trading. He says that hedge funds wield such massive influence that many stocks are now completely disconnected from their underlying businesses.
That's why it's so hard to establish a buying price. Cramer says that until the hedge funds "finish selling or some buyers -- real corporate buyers -- come out of the woodwork, it's not going to get any easier. And it simply may not be worth your effort, your time or your sanity."
In the last ten years, the number of hedge funds increased from 600 to 13,600 with assets under management zooming from around $100 billion to an estimated $2.2 trillion. This means that hedge funds, which are not regulated by any agency, represent as much as 60 percent of all global trading.
Hedge fund managers typically are expected to come up with at least a 20 percent return for their clients. That means they need quick returns--and they'll do almost anything to satisfy their investors from spreading rumors and using leverage, as well as long, short, and derivative positions. This churns up volatility and causes the stock market to feel like Hurricane Ike.
So what should individual investors do if the stocks they hold are at all-time-lows--hold them until they come back, or get out now before short sellers drive prices to the point they're worthless? Ask anyone who still holds Lehman Brothers, the giant insurance company AIG, or Merrill Lynch then stand back as they hurl.
As for those risk-reward scenarios, there are some charts that say now is the time to buy financials. But that's not necessarily true for individual investors looking at individual stocks.
Let's take Merrill Lynch. Citigroup issued a report on Friday (September 12), calling Merrill a "buy" because as it valued the company's fundamentals at $45 a share. But Merrill actually closed out the week at $17.05, a new 52 week low. Why? Because in the mind of many hedge fund managers, Merrill is infected with the same toxic debt that destroyed Lehman Brothers and Bear Stearns, and there was nothing Merrill could do about it.
And then there was Fannie Mae and Freddie Mac. Individual investors were still pouring money into the two government sponsored mortgage companies after being reassured a government takeover wouldn't be necessary until it was.
Most investors are aware that stock investing carries some risk and that share prices can collapse if the business fails. But these days the business can be just fine, while the stock price continues to drop.
One logical alternative solution would be for individual investors to simply put their money into mutual funds. But wait. Aren't there reports out there that say three out of four mutual fund managers underperform the stock market when you take their fees into account?
So what should individual investors do? As long as the stock market is being controlled by hedge funds, you might want to consider low cost index funds. At least that way the up and down swings will mirror whatever index you've invested in and not some company the predatory short sellers have targeted as their next victim. If you had an index fund tied to the Dow Jones Industrials, you would have been up slightly for the week.
That said, many investors have a difficult time determining when they should sell an individual stock, especially when it has lost most of its value. There's the temptation to hold on until the price comes back. But it may never come back.
Financial advisors will give you some parameters when it comes to selling stocks. For example, you shouldn't allow individual stocks to lose more than 10 percent of what you bought it for. Individual stocks are volatile and you should cut your losses quickly. Too many investors act like deer in the headlights and freeze up when their stocks prices drop. So when you buy a stock, you should write down the price you will sell at and stick with it. The bottom line is that you want to make sure you sell losing stocks before they turn into bottomless pits like Lehman and Bear Stearns.
Of course, for those high rollers out there who still feel the urge to place their bets on this roulette wheel of a market, you may be able to select a few individual stocks. Cramer, for example, recommends FedEx and Sears. Just be careful and be ready to move quickly if their prices begin to fall too far too quickly.
For those true long shot bets, you may also pick the next Google. Just keep in mind that Google is now selling for around $435 a share after going up to $747. If you bought Google at $747 you lost $300 a share in the past year.
And even Jim Cramer, who touts stocks for a living, says that unless you can devote four hours a week to study a stock's fundamentals, go the index fund route.