In returning to the stock market, investors have mostly avoided individual stocks in favor of funds and ETFs...and that may be the smartest thing we've done in a while, writes MoneyShow's Howard R. Gold, also of The Independent Agenda.

Someone must have sounded an all-clear signal on New Year’s Day, because in January, after five years of fasting and penitence in the bond market, investors poured money into US stocks.

But much of that money probably went into stock funds and exchange traded funds, not individual stocks. Though few stats are available, there are many indications individuals have abandoned individual stocks as their preferred form of equity investing. Remember how people worshipped Cisco Systems (CSCO), Qualcomm (QCOM), and JDS Uniphase (JDSU) back in the 1990s?

Now they’re buying target funds, index funds, and their close cousins, ETFs, instead of individual stocks. With one big, bright red exception, which we’ll get to later, individual stock investors may be a dying breed.

Nothing brought that out more starkly than an article last week in The Wall Street Journal (subscription required), which dealt with the demise of investing clubs, that former pop-culture icon. (Remember the Beardstown ladies?)

Investment clubs flourished in the era of do-it-yourself investing, when every man and woman was their own stock picker. Who needed professional managers when all the data was right at your fingertips? Especially when friends and neighbors could help each other find winning stock ideas.

Well, it didn’t quite work out that way. As The Journal reported, BetterInvesting (formerly the National Association of Investors) has seen membership at investor clubs plummet from 400,000 at its peak in 1998 to only 39,000. That’s a plunge of 90% and reflects the ravages of a decade that saw two major bear markets. The problem, The Journal wrote: “Stocks aren’t fun anymore; they are scary.”

Especially individual stocks. Yes, anyone who stuck with equity funds through the Lost Decade lived in a world of hurt. But owning the wrong stocks—like, say, Citigroup (C) or Akamai Technologies (AKAM)—was pure torture. And investment clubs that tried to go against the tide were doomed to fail, as many of them did.

  • Read Howard’s take on why many individual investors are hopeless cases on MoneyShow.com. 

The American Association of Individual Investors, another organization that focuses on investor education (of which I am a member), saw a more modest decline in its membership, between 10% to 15% from before the financial crisis. It now has around 150,000 members, president John Bajkowski wrote in an e-mail.

But AAII members have changed their behavior, too. Surveys of members’ asset allocation show a big drop in how much they put into individual stocks. In March 2000, AAII members had 41% of their portfolios in individual stocks. That hit a decade low of 16.7% in February 2003, and last month rested at 29%.

Stock fund holdings also fell from 41% of members’ portfolios in January 2000 to 32.5% last month. So, they’ve come back a bit more from their lows than individual stock holdings have—and in an organization that emphasizes disciplined stock picking.

NEXT: Can You Really Make Money in Individual Stocks?

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Therein lies the problem. Anyone can buy a set-it-and-forget it target-date fund and get decent exposure to equities or put together a reasonably diversified mix of index funds or ETFs and participate nicely in bull markets. But picking winning individual stocks takes work, time, and skill, a skill which only a small number of even professional managers have—and the vast majority of individuals don’t.

The research on individual stock ownership is voluminous and overwhelmingly damning. Just one example: Brad Barber and Terrance Odean of the University of California showed in a 2011 study that individual stock pickers made every mistake in the book:

  • underperforming index funds
  • selling winners and keeping losers
  • not learning from past errors
  • and holding undiversified stock portfolios

And through it all, they evinced a delusional overconfidence in their own abilities.

If individual stock pickers keep letting their emotions get the best of them, there’s a reason for it: People get attached to individual stocks in a way they don’t to, say, the Vanguard Total Market ETF (VTI).

Exhibit A, B, C, and D: Apple (AAPL), of course.

Last October, USA Today reported, nearly 17% of all individual investors owned Apple stock, more than four times the number that owned the Dow Jones Industrial Average. And that one stock comprised 17%—yes, you read that right—of the portfolios of individual Apple shareholders. That’s just nuts.

"’I don't want to diversify that much when I have one stock doing just fine,’" said one Apple shareholder, whom I mercifully won’t name and had 38% of his portfolio in Apple shares. And that’s the problem with falling in love with individual stocks—they don’t love you back when you really need them to.

As I wrote a couple of weeks ago, Apple shares fell more than 37% from their peak, wrecking the portfolios of true believers (who attack anybody who writes a critical word about Apple, but conveniently don’t disclose their own stake in the stock).

Only a very small number of individual investors can invest successfully in individual stocks—and if you have any doubt about it, you’re not one of them. Even then, they should limit individual stock holdings to no more than 10% of their total portfolio.

As for me, I do believe in actively investing with 10% to 20% of my holdings, but I do it mostly with ETFs. I gave up on individual stocks a long time ago.

Give me the boredom of an index fund over the drama of an Apple or whatever the latest high flyer is. I’d prefer to get my entertainment elsewhere.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. Follow him on Twitter @howardrgold and catch his coverage of politics and the economy on www.independentagenda.com.