It’s one of the most common debates in the investing world: Individual stocks vs ETFs. There’s no absolute right answer, but you can still find an answer that fits your needs!
The stock market offers an enticing vision of consistent wealth building for investors. However, the reality doesn’t always match up to the vision in real life. Stocks fluctuate in value, and while long-term gains may be the objective, intermediate downturns can be quite frustrating.
To help mitigate short-term volatility, many investors diversify their holdings by choosing a variety of individual stocks from different market sectors. Others, in contrast, prefer to use exchange-traded funds or ETFs to diversify their portfolios. They’re both valid approaches, but there are important differences between individual stocks vs. ETFs.
Ultimately, the question of investing in individual stocks vs ETFs is a personal matter based on one’s financial objectives, expertise, time frame, risk tolerance, and other factors. Still, by understanding some crucial differences between the two approaches to equities investing, one can hopefully construct a more tailored portfolio with an appropriately balanced risk-to-reward profile.
The Main Pitfall of Individual Stock Picking: Risk of Failure and Loss
As long as stock picking offers thrills and the possibility of life-changing returns, the never-ending individual stocks vs ETFs debate will always have legs. After all, if you’ve read in the financial press about triple-digit percentage gains in specific stocks, it may be hard to resist the temptation to go all in on a handful of high-conviction stocks in hopes of similar outperformance.
Past performance isn’t a guarantee of future results. Picking the next Tesla or Amazon is like finding a needle in a haystack – or really, like trying to grab a specific needle among a cluster of really sharp needles. If you pick the wrong ones, you (or more precisely, your portfolio’s value) could get badly hurt.
Sure, it’s obvious now that Tesla and Amazon stocks were bound to post huge returns. However, hindsight is always 20/20, and these stocks were much more speculative and uncertain in the beginning. Like the majority of the thousands upon thousands of startups out there, Tesla and Amazon could have failed to gain market share. Their shares could have lost much or even all of their value. They could have ended up like Pets.com stock, which seemed like a surefire winner during the dot-com bubble of 1999 but went to zero after the dot-com bust in 2000.
Thus, the primary pitfall of individual stock picking is the risk of failure. That doesn’t have to mean failure on the investor’s part. There could be a failure of the business or the market sector, which isn’t within the investor’s control. This failure could be a function of fierce competition within a market segment, fluctuating macroeconomic conditions, shifting consumer preferences, and a host of other extrinsic factors, along with company-specific factors such as executive-level changes (like the CEO changes that General Electric underwent throughout the years).
Other Issues With Individual Stock Picking: Time, Effort, and Expertise
Now, individual stock pickers might argue that not everyone is trying to beat the odds and pick out the next Tesla or Amazon. That’s certainly true, as it’s entirely possible to stick to established, tried-and-true names like Coca-Cola and Apple stock. After all, Berkshire Hathaway CEO Warren Buffett is famous for highly successful stock picking, so why shouldn’t everyone give it a try?
The answer is that we can’t all be Warren Buffett. He has time during the day to conduct deep research on individual companies, while most people have jobs, school, children, and/or other demands to attend to throughout the day. Plus, even with the help of the internet, it still requires a great deal of effort to conduct thorough research on individual stocks. In some ways, the internet makes the task more difficult: the sheer amount of information we have at our fingertips can be overwhelming. Buffett has plenty of people to help him conduct that type of research, and they have deep expertise in the financial markets, as does Buffett himself.
In contrast, the average individual investor only has surface-level knowledge of businesses and stocks, if any knowledge at all. Even if you have plenty of spare time and are willing to put a great deal of effort into researching individual businesses, you’ll still be competing against institutional investment firms with deep capital and human resources. It’s an awfully tough game for individual investors to play, not to mention win.
If you insist on toughing it out and trying your hand at individual stock picking, at least do it the right way. As Buffet himself said, “Never invest in a business you don’t understand.” Focus on stocks representing businesses and industries of which you have firsthand knowledge, or at least extensive familiarity.
For example, it might make more sense to invest in Starbucks stock if you see that there’s a Starbucks in every town you visit and the company practically has a monopoly in the coffee-shop market, as opposed to buying an obscure stock representing a company halfway across the world with products you’ve never actually seen or used.
Additionally, individuals who want to try stock picking could try it first with paper trading. Then, if the virtual trading yields satisfactory results over an extended period of time, they could try it with a small portion of their portfolios to limit risk.
ETFs: An Easier Way to Invest
In stark contrast to the often risky and time-intensive world of individual stock picking, ETF investing puts the burden of time, effort, and expertise in the hands of fund managers. Like Buffett, ETF managers spend a great deal of time researching companies and have access to vast human and capital resources that individual investors generally don’t have.
Granted, ETF investors will be required to pay a fee to hold the ETF. That fee is called an expense ratio, and it will reduce your returns, but usually not by very much.
For instance, the most popular ETF in the world, the SPDR S&P 500 ETF Trust (ticker symbol SPY), has an expense ratio of 0.09% per year. That’s less than one-tenth of a percent you’d pay annually for holding the fund, and you’d get weighted exposure to a diversified basket of 500 large-cap companies. Not a bad deal, really, as you can let the fund managers do the hard work for a minimal annual fee.
☝️ Be aware, though, that those expense ratios are subject to change and can vary widely among ETFs, so be sure to check any particular fund’s expense ratio before considering an investment (sorry, but you’ll have to do a little bit of research – there’s no way to avoid it completely).
Remember that you pay a fee when you invest in individual stocks as well. Effective stock research takes a large amount of time, and time has value. If you calculate the value of the time it takes you to build a portfolio of well-researched stocks, the cost is likely to be higher than the expense ratio of an ETF!
Besides, ETFs are almost as varied as individual stocks nowadays, so you can craft an ETF-focused portfolio to meet your particular objectives and preferences. Among the most popular and low-cost ETFs are the technology-heavy Invesco QQQ Trust (ticker symbol QQQ; expense ratio of 0.2%), the giant-company-focused SPDR Dow Jones Industrial Average ETF Trust (DIA; 0.16%), and the small-company-inclusive iShares Russell 2000 ETF (IWM; 0.19%).
Finally, it’s worth noting that investing in ETF vs. stocks isn’t an either/or proposition. Investors can hold a combination of ETFs and individual stocks – though again, stock picking involves certain risks and needn’t be overrepresented in one’s portfolio.
So, feel free to pick out individual stocks if you’re so inclined, but be aware that you’d be competing with some of the best researchers in the business. Or, you can give ETF investing a try, and align yourself with those researchers for a relatively minimal fee, and hopefully for enhanced risk-adjusted returns over time.
The Emotion Factor
There are some good reasons to try picking your own stocks, and also some that are less good. If you frequent investment forums on the internet, you quickly see that individual stock pickers dominate the boards. They earn prestige in the community by presenting and defending their research, and they are often the most respected figures on the forums.
ETF investors, on the other hand, may be dismissed as less sophisticated investors that deserve less respect.
It’s natural to seek a role in a community that brings prestige and respect within that community but moving into stock-picking to impress a Reddit group can be a very bad idea. If picking stocks fits your goals and your strategy and you have the necessary time and expertise, go for it. Don’t do it to impress anyone!
Your portfolio contains your money. The decision on how to manage it is yours, and it’s in your interest to make a decision that fits your needs. If you assess your options, your own expertise, and the time you have available, you can make an informed choice and be confident that you’ve made the right choice!