Whether you are a seasoned investor or someone just looking to get their feet wet, one of the biggest decisions in the investment industry today is whether or not to invest in stocks or move towards an ETF.
Of course, there are a plethora of investment methods and these two aren’t the be-all-end-all, but they are definitely the most popular. Mutual funds, for good reason, are losing popularity and ETFs and DIY stock investors are increasing every single day.
I’m going to explain what exactly a stock is, and what exactly an ETF is, plus some pros and cons to investing in stocks and ETFs. I really hope it brings some clarity to a very frequently occurring question that most new investors really don’t know the answer to.
Ok, so what exactly is an ETF
An ETF, or Exchange Traded Fund, is very similar to a mutual fund in the fact that it owns a “basket” of securities. These can be stocks, bonds, REITs or many other securities. The main point to drive home is that when you are buying an ETF, you aren’t simply buying a single stock.
Say you want exposure to the Canadian oil and gas industry. Crude is on the rise, and you believe these companies will be making a comeback in 2018. But you just don’t exactly know which stock is going to perform the best.
Instead of going back and forth on which to buy, and potentially losing sleep over picking the wrong one, you decide to check out ZEO, which is BMO’s Canadian oil and gas ETF. You now have exposure to 10 different companies, including Suncor, Imperial Oil, and Cenovus.
What are some of the benefits to purchasing an ETF
Well, the first thing I will bring up, and I almost always do when talking about ETFs, is their fees compared to mutual funds. ETFs are for the most part passively managed, the fees tend to be exponentially lower. Compare the average MER (Management Expense Ratio) of a mutual fund, which is 2.35%, to an ETF, which is 0.44%. You are saving almost 2% a year.
Now, it doesn’t seem like much, but if you’re incurring that charge every single year over the life of the portfolio, it can possibly end up costing you $300 000!
Secondly, ETFs can give that feeling of instant market diversification. Instead of picking individual stocks and having to purchase 10 or more to properly diversify your portfolio, a few ETFs can do the trick. In fact, you could even purchase an ETF like SPY, which tracks the whole S&P 500 index in one click, and more importantly, one commission charge.
And finally, ETFs are just easier. It’s that simple. Picking individual stocks is insanely hard to be good at, and very few new investors find success. It often takes years and years of trial and error, along with building a knowledge base to become profitable.
So what are some of the downfalls of ETFs?
ETFs seem like an amazing solution to a new investor struggling to enter the markets, but they also have their downfalls. For one, there is no “home run” potential when it comes to ETFs. An individual stock picker, through extensive research, may find a company they feel will be an up and coming powerhouse in an industry.
They may purchase that stock, and 10-15 years down the road they may see returns that were more than likely simply unachievable with an ETF. Most ETFs, and keep in mind that I am saying most, contain large cap stocks that simply don’t have the potential to grow as much as picking an individual stock that has the potential to become an industry leader one day.
Even if you were to have one of those stocks contained inside the ETF, chances are that company makes up less than 10% of the funds holdings, so the returns wouldn’t be as large as if you were to own that company outright with the same dollar value.
Another disadvantage is the fact that ETFs trade like stocks. Although a ton of brokers today offer the commission free purchase of ETFs, you’ll more than likely pay a commission selling them.
The success of an investors profile hinges on a ton of potential mental traps, an investor may find themselves buying and selling these ETFs too frequently, to the point where they are actually paying more to manage their portfolio of ETFs than they would be with mutual funds or individual stocks.
Let’s move on to stocks
Stocks are the bread and butter of the financial markets. Everyone talks about them, and everyone who is involved in the capital markets seems to have a piece of at least a few of them.
Unlike something like ETFs, most people know what a stock is. So I’m not going to waste your time going over what exactly a stock is.
What are some of the benefits of purchasing an individual stock?
Because there are so many types of stocks, I could potentially sit here for hours talking about the benefits and downfalls of each. Instead, I’m just going to highlight a few key areas that you’ll need to know.
For one, and this is probably the most popular reason to invest in individual companies, is the dividend. Not all stocks provide dividend income, in fact, most up and coming growth stocks do not. You’ll more than likely see a stable dividend payment from a large cap established company like Apple. Keep in mind that when I say stable, I mean the company isn’t putting themselves in danger when issuing a dividend. You can find situations where companies are simply issuing too much of a dividend, and it is putting their company in danger.
The benefits to dividends come in multiple ways. For one, because you are purchasing an individual stock, you are still exposed to is appreciation over time. If a stock goes up 7% in a year and issues a 3.5% dividend, you’ve earned 10.5% on that investment, an above average market return. Secondly, the ability to DRIP (Dividend Re-Investment Program) your dividend payments back into more stocks, usually commission free, allows you to compound your returns and start earning dividends on those dividends. Over the long haul, this can create what we call a snowball effect. As the snowball rolls down the hill, it gets bigger and bigger.
A second advantage to purchasing individual stocks, especially growth stocks, is the ability to achieve better than average market returns. There is a multitude of investment strategies out there, but one that is particularly popular is investing in high potential growth stocks.
The objective is to find up and comers in a certain industry who have the potential to establish themselves as leaders. The added risk (and there are lots) to doing so is the potential to make 5, 10, or even 15 times your initial investment. Investing in growth stocks, which is a particular strategy I follow, takes a ton of mental discipline, and really shouldn’t be attempted by anyone until they are comfortable doing so.
And finally, one advantage of individual stocks that may not occur with ETFs, is their liquidity. Unless you are investing in some very speculative companies, stocks tend to trade quite often. What this means, is often the price that the stock sits at when you are looking to sell, is the price you are going to get. This isn’t always the case with ETFs, as some are thinly traded, and you may get stuck with a purchase you may not be able to get rid of, at least not at the desired price.
So what are some downfalls of investing in stocks?
One of the key downfalls of individual stock picking is people simply don’t have the time or knowledge to do the correct amount of research. This drastically increases your risk for ruin, which is exponentially higher picking individual stocks rather than investing in a fund. It is absolutely imperative that you know what you are doing before you do it.
Another downfall of individual stock picking is simply getting into the market at the wrong time. A lot of people think they can time the market, but very few people actually can. In fact, I would argue the fact that nobody can. Now, getting into the stock market prior to a correction or bear market isn’t that big of a deal. Over time, historically the market has always recovered and investors who stuck with it have been rewarded.
The inherent problem with this is often the human mind. When we buy at the highs, and then are faced with crushing lows, we often tend to panic and sell. We forget the reasons why we bought the stock in the first place and ignore the fact that those fundamentals may have not even changed.
Mental stability is a huge downfall when it comes to picking individual stocks, as a lot of people can only take so many right hooks until they bow out of the fight. This is something that simply takes time and mental training to avoid, but it is absolutely key to master if you are going to be picking individual stocks.
So, now that you know some of the pros and cons of each, which one will you choose?
It’s not an easy decision. Not to mention the fact that there are numerous other ways to invest your money other than ETFs or stocks. But, for the purpose of this article, I’m going to assume you want to choose one or the other.
If you simply want an investment solution that is somewhat going to allow you to “set and forget”, ETFs may be right for you. Individual stocks require a ton of monitoring and initial research to purchase, down to specific company financials and keeping up with company news, acquisitions, and the like.
With ETFs, you may be able to just simply research an industry as a whole, recognize it’s upside, and pick one that will follow that industry. Or, to make things even easier, just purchase an ETF that tracks a particular countries index, and watch your money grow.
With stocks, particularly being a DIY individual stock picker, the road is longer, more tedious, and more rewarding. Picking the right stocks for your portfolio requires a ton of research and exponentially more hours to maintain than an ETF. But, time is money, and you could be rewarded handsomely if you make the right decisions.