Image via WikipediaA comment I have read on other blogs around stock portfolio reviews or selection has been:
‘Why not buy an ETF instead of stocks !?!’
… and so I thought I would share my opinion on why I pick stocks over ETFs for the moment. To start with, it’s important to understand what a company stock and an ETF is.
A company stock represent a number of shares from a company trading on the stock market for the value of the company. You basically buy a little part of ownership in a company with every shares you buy.
An ETF is an Exchange Traded Fund and what you buy are shares in the fund which consequently holds multiple company stocks. Different ETFs will have different guidelines on what they own. Some will be sector based and others index based. It’s also trading on the stock market unlike mutual funds.
ETFs can reduce your risk
Mathematically speaking, when you buy an ETF share, your purchase owns a specific percentage of the holdings from the ETF. For example, if you invest 1000$ and the ETF holds 20 companies with 5% equally invested in each company, you will have in essence 50$ invested in 20 different companies. If you compare that with a 1000$ in 1 company, you can see that in one case your investment has exposure to 20 companies and in the other you have exposure to only 1 company. The risk is higher when you invest in one company. The benefit of an ETF over an individual stock is to reduce your investment risk.
Stock investing can be more profitable
The flip side of the coin is that your return on investment is based on the average value investors assign to the ETF holdings on the stock market (very different from a mutual fund) and the ETF may move slower than an individual equity on the stock market due to its many holdings. It’s basically a risk over return decision. The key question for many investors is whether or not your skills can beat the performance of the ETF? More so if the ETF follows an index.
Dividend investing in all its glory
With respect to dividend investing, one of the main criteria for buying dividend paying stocks is to reap the rewards from dividend growth over the years to increase your yield on cost. It’s like getting a pay raise just for showing up. Dividend aristocrats are expected to grow their dividends every year providing investors with a yearly growth independently of the value of the stock on the market. When you combine that with an increase in stock price, it can be quite significant. This is where an ETF doesn’t keep up at the moment (based on my research). I have not found any ETFs with regular dividend growth. Not to mention that ETFs have not been around for that long when you compare it with dividend aristocrat companies that have been paying dividends for over 100 years. Time and regular growth is what powers dividend investing. Start early and reap the benefits!
To answer the initial comment I started with, I feel that ETFs have a place in a portfolio just like fixed income have a place, it’s just a matter of identifying your risk versus reward goals. It’s also important to understand your portfolio risk allocation based on your age. Just saying to buy ETFs over dividend stocks doesn’t cut it as I would suggest some banks to a young adult over a financial ETFs but for a much older person, I would reverse my comment. The account you invest in may also have to be factored along with the investor’s skills. Index investing is a very good approach if you don’t want to spend much time researching and an index ETF can be a very good choice.
Readers: Do you have a rule of thumb for buying ETFs?