I’m a big fan of dollar-cost-averaging your monthly investments into index funds for the majority of your portfolio. For the smaller, higher-risk portion of your portfolio, I propose an alternative to choosing individual stocks. Hopefully this should come as no surprise to you, but properly choosing individual stocks is an incredibly challenging undertaking. I’d argue that it’s harder than calming a screaming infant at 3am when all you want to do is sleep (if you don’t have kids yet, just wait…). So here are my top 10 reasons to part ways with individual stocks and go with specialized or sector ETFs instead.
1. There are too many unknowns with stocks.
I’ve read numerous stock analysis books like Phil Town’s Rule #1 and Benjamin Graham’s The Intelligent Investor, investment newspapers such as Investor’s Business Daily, and countless websites proclaiming to have “cracked the code” on stock investing. I’ve also scoured volumes of stock data provided both free and paid on the internet. Yet, even with this wealth of knowledge at your fingertips, there is so much information about a company that you just don’t know. They’re required to provide a certain amount of data that is publicly available, but in the end it’s only part of the story regarding a company’s fundamentals. Unless you’re the CFO, there’s no way you can know all the information about the future of a company.
2. Sometimes, stuff happens.
A perfect example of this is Chipotle Mexican Grill. In late 2015, the company was looking great with its stock hitting all-time highs. Everyone loved their burritos, with lines for their restaurants often out the door. Life was good for Chipotle… until they suffered an E. coli outbreak in October 2015. The stock suffered a 42% decline in less than 3 months — who could have seen that coming???
3. Stocks are extremely volatile and labor-intensive to track.
For one, choosing stocks to buy and monitoring them for selling opportunities takes a lot of work. Do you really want to be following the stock market every day? Analyzing tens of articles to get the latest on the direction of the company? Pouring through quarterly earnings reports? I, personally, would rather spend that time with my family doing something fun. Life’s too short to spend it over-analyzing stock data, not knowing whether the key item you are searching for is available to the public or not (see #1 above).
4. You can’t go on vacation.
OK, so maybe you can go on a vacation, but are you really going to step away from the market long enough to enjoy yourself? Or will you constantly be thinking in the back of your mind, “What if my stocks are crashing right now?” For the most part, you can step away from sector ETFs for a week or two and expect that your balance won’t have changed significantly.
5. You can more predictably buy low and sell high with sector ETFs.
It’s much easier to track an entire sector than it is an individual company. Just reading through a few news articles will give you the general vector of a sector, which could be enough to identify a sector ETF’s bottom or peak. Don’t get me wrong — you still need to do a significant amount of research to make sound decisions, just not as often as with an individual stock that will likely be more volatile.
6. Stock diversification is incredibly time intensive.
To realistically diversify, you’re likely looking at buying at least 20, if not several more stocks — you need to choose from the various industries, as well as the 3 main business size classes. But then you’ve only sampled a few different sectors and different size businesses. With most sector ETFs, they typically carry the advantage of including large-, mid-, and small-cap stocks. You then need to only diversify across sectors rather than both across sectors and business sizes. Cutting the number of securities you have to track by 1/3 is a substantial time-saver.
7. The odds of choosing the next great stock are pretty low.
Don’t believe me? Let’s take a look at the SPDR S&P Biotechnology ETF (XBI), which is composed of 94 holdings chosen by professionals. Over the last year, it has returned 37.7% — pretty good, right? So, let’s take a deeper dive:
- XBI is an “equal weight” fund, where stocks are weighted equally regardless of company size.
- The weighting range spans 0.10% – 2.68%, with a median value of 0.75%
- Out of the 94 holdings, only 36 holdings (38% of portfolio) beat the portfolio return. And of those, only 19 (20% of portfolio) were weighted above the median values, indicating that the portfolio manager thought that about half of the higher gainers were pretty risky bets.
In plain English, it means that if you were fortunate enough to have narrowed down your stock choices in the biotech sector to the ones that the XBI portfolio manager chose, you have a 2 in 5 chance of beating the portfolio return, and only a 1 in 5 chance of choosing a winner that’s not high risk.
Finally, it’s worth noting that 23 holdings (24% of portfolio) have negative returns over the last year. With a 62% chance of choosing a stock that does worse than the overall portfolio, and a 24% chance of picking a loser that costs you money, do you still think you can consistently choose the next great stock? I like to gamble in Vegas, but not on games with those kind of odds… why would you turn investing into a gamble?
8. The psychology of investing is tough!
To be a successful investor, you have to think critically and apply some serious brainpower to analyzing the security you would like to invest in. This is not easy… and in actuality is quite exhausting. Especially when you consider the angst you have to deal with when the day after you buy a stock, it goes down 5%! You start questioning yourself:
- “Did I make the right choice?”
- “What did I miss?”
- “Is this an indication of worse things to come?”
- And ultimately, “Do I get out and sell before things get worse?”
We preach maintaining your composure while investing, but it honestly is much more difficult when you consider the greater variability of individual stocks compared with sector ETFs. Don’t get into a situation where your emotions are guaranteed to get the best of you and drive poor decisions.
9. Psychology Part II — the true benefits of individual stock investing come from long-term holding… for decades.
If you bought Apple a few years back and sold today, you’d make a pretty good profit. Compare that with having bought in the 1980s — your stock would be worth millions! Again, it’s extremely difficult to choose these rare lifetime high-performers in their infancy, but if you do get lucky it’s imperative to ride the cycles, take advantage of the stock splits, and just hold on for the ride. This is obviously an oversimplification, and unfortunately much easier said than done!
10. A fallen angel may never recover.
If you’re really unfortunate and pick the next Enron, there’s no guarantee that it will ever return to greatness. Sector ETFs, on the other hand, have the luxury of being able to dump the losing company and pick up a better fit with a greater chance of producing positive returns, while not letting one company take down the whole ETF. Looking back at XBI, the worst performer lost 76% over the last year, but it only composed 0.34% of the entire portfolio. At such a low percentage weight, assuming it doesn’t recover, the fund manager could easily drop it from the portfolio and owners wouldn’t even know the difference.
Don’t get me wrong – I love the opportunity that individual stocks give to investors to find a company they love for all the right reasons (great product, solid fundamentals, etc.) and buy their stock, I just don’t think it’s for everyone. Specialized or sector ETFs help provide a targeted diversification at a very low cost (fees typically around 0.35%), rather than just plowing your money into a broad-market index fund. Do your own research, formulate your own opinions, but I think in the end you’ll discover that these ETFs offer a fantastic opportunity to make substantial gains with much less workload, worry, and risk than trying to pick the next great stock.
What do you think? Are you sold on stock picking as a way to specialize in addition to broad market index fund investing? Or might a sector rotation strategy be a better option than buying individual stocks? Please let us know your thoughts!