If there is one thing Wall Street gets right, it’s giving investors choices. One choice that all investors eventually encounter is how to put their money in the market. There are generally two options for the semi-active investor: ETFs and individual stocks.
What’s an ETF?
ETFs are like mutual funds without all of the overhead. When you buy a share of an exchange-traded fund, you own a share of the investment pool the ETF owns. The fund can be indexed to a particular stock index, or actively-managed by an asset manager. For example, the SPY ETF owns all the stocks in the S&P 500 index. Buying SPY is like buying 500 different stocks with one single trade.
When to Use ETFs
Exchange-traded funds are great when an investor wants exposure to a variety of different stocks. Here are a few reasons why you might want to invest in ETFs:
1. Diversification – ETFs can be great for diversification. An ETF like the Market Vectors Gold Miners ETF (GDX) holds 32 different companies that are all involved in gold mining. The Russell 1000 Index Fund (IWB) holds shares of stock in the 1000 largest publicly-traded companies on the stock market. ETFs can be used to buy diversified positions based on industry, geography, or broad indexes.
2. Access – ETFs also give investors the option to invest in markets that are otherwise inaccessible on the stock market. The ETFS Physical Platinum Fund (PPLT) allows investors the opportunity to buy platinum on the stock market. The United States Oil Fund (USO) gives investors a proxy to own oil. And hundreds of bond ETFs make it possible to invest in bonds with a stock brokerage account.
3. Low costs – ETFs charge a small annual expense fee on fund assets. You will also pay commissions to buy and sell an ETF. Many well-known brokerages like TD Ameritrade, Charles Schwab, Fidelity, and others have programs that give investors commission-free ETF trades.
ETFs work best when an investor has some kind of idea about a broad selection of companies. If you think the emerging markets like India will be red hot for growth, you might buy an ETF of Indian stocks. If you think gold prices are going to rise, you might buy a gold miner ETF to capitalize on gold prices.
When it comes to broad ideas that are not company-specific (all gold producers benefit from rising gold prices, and all Indian stocks would do better with better than expected growth in India), an ETF makes the most sense. You don’t need to know much about the individual companies in an industry when you use an exchange-traded fund.
ETFs are limited, however. Investors should read the prospectus for an ETF before making an investment. The prospectus defines how the ETF will be managed, how much it costs to hold the ETF each year, and tax information surrounding any dividends or disbursements to investors.
When to Buy Individual Stocks
Investors always have the option to invest in individual stocks. Buying individual stocks makes the most sense when you have company-specific insight that you think will give you a market-beating return.
Individual stocks offer:
1. More upside potential – When you buy an ETF, you’re limited to the average return for a collection of investments. A single stock investment gives you much more upside potential, but also more downside risk. It is very possible for a tech company to go bankrupt, highly unlikely that the whole industry represented in the Technology SPDR ETF (XLK) to go broke at the same time.
2. More room to add value – Individual stocks provide investors with more opportunity to uncover information not yet priced into the stock. An individual stock investor needs to know about company management, the financials of individual firms, and the company’s competitive standing in the marketplace before making an investment.
Individual stocks have their downsides. Individual stocks are much more costly to trade than ETFs. Whereas hundreds of ETFs can be traded for free, you’ll encounter a commission for every individual stock you buy and sell. For this reason, individual stocks make a good investment only when you have a significant amount of money to invest. If you pay $10 to buy and sell $1,000 of stock, you’re down 2% from the very start. Making up that difference is more difficult than most think, so invest in individual companies only when the commissions make up a very small part of your total investment. A $20 charge to buy and sell stock is much more manageable when you’re investing $10,000 instead of $1,000.
This may only be me, but the main reason to go from ETFs to individual stocks is wanting to get higher returns. If you think an ETF will give you a higher return than investing in individual stocks, you have to stay with ETFs because of the safety their diversification brings you (unless you go for some of the crazy and exotic leveraged ETFs).
Diversification reduces risk. The fundamental reason people would want to reduce risk is to reduce losses. However, it also reduces reward.
As with anything in life, you get nothing for nothing. If you want to get a higher reward, there is a little extra work you need to put in. Properly investing in individual stocks requires doing at the very least some rudimentary research. Doing the extra work opens the door to higher returns, but there are never any guarantees.
All that said, my preference is for investing in individual stocks. I’m a geek by nature, so the adventure of learning about some company appeals to my temperament. Touch wood or praise the Lord, I’ve done much better than most funds, so this is what I’ll continue doing.
In fact, someone suggested I start a website dedicated just to investing in individual stocks because I’ve done so well with it. I don’t know that there are many people interested, but if there are, who knows?
I am a big fan of ETF’s. They give my portfolio diversification yet I can trade them more actively than mutual funds.
Most of my holdings are in ETFs. However, I did purchase some shares of individual stocks that appeared to have real upside potential. They also pay decent dividends. So far so good.
Question, I set my dividends to re-invest. But, I’ve read others that take them as cash and then put them where they want. I guess they aren’t convinced that they want to pay the current price of the stock they hold. Thoughts? To me it seems more like interest compounding when they are re-invested. Now your portion of the divided will also earn dividends.
ETFs make investing and profiting from the stock market easier with lower number of trades as compared to what one would trade under individual stock buying. Lower costs are a major attraction for ETF investing. However, earlier the stocks and bonds had an inverse relation which meant that if you have share and bonds in your portfolio and if the share market isn’t doing well, you still hedge your wealth with profits from bonds. According to Bill Gross, this has shattered http://www.meritgold.com/market-updates-detail/viewpoint-the-death-of-the-balanced-portfolio. I believe this raised the need to have tangible assets like gold and silver bullion in ones portfolio.