Wednesday, November 2, 2016

Stocks vs ETF's - Which Should You Buy?

There has been a long standing debate about buying individual stocks versus ETF's(exchange traded funds). There are debates raging on stocks versus mutual funds(around before ETF's), and still more debates regarding mutual funds vs ETF's. How is the average investor supposed to figure this all out with a family involved in plenty of extra curricular, and Sunday dinner? While all the topics above are not in the scope of this article I'll start scratching the surface.

Here is a simple breakdown of the Stock vs ETF debate.  Many investors start out thinking they need to hold individual stocks. They think they need to buy up all the stock of companies with the newest technology and hottest products. The only problem is if you have a lot of wealth tied up in one company or two companies when the ship starts sinking watch out! 

That is why mutual funds, and eventually ETF's were created. They were designed to help you buy an entire index, asset class, sector, or sub-sector with relative ease. You could now buy in one transaction a basket of individual stocks with only one price to follow. The idea is you could reduce risk by holding multiple securities in an industry or index. This risk is referred to as "stock specific risk".

There is a caveat.
Reducing "stock specific risk" does not mean you've reduced all risk.  Your risk has now manifested itself into index based risk, country based, sector based, market cap based,  or commodity based risk to name a few. 

So knowing that we still have risk with either stocks or ETF's how is the average investor to proceed from here?  Unfortunately there is no set answer. Since every one's risk tolerance is different all I can do is provide a guide designed to help you reduce risk.

So let's proceed with an example

Imagine we have an investor just starting out. They are young, confident, smart, and eager to get ahead. They have $30,000 to invest and are absolutely certain they've identified some companies that will help them achieve just that. They decide to allocate the money evenly between the three companies identified.

This investor has determined Habit Restaurants(HABT), Johnson & Johnson(JNJ), and Coca Cola(KO) are all due to have a spectacular year. After one year* this is how each has performed. 


HABTJNJKOTotal
Starting Value$10,000$10,000$10,000$30,000
1 Year Performance-40.70%18.10%3.28%
Ending Value$5,930$11,810$10,328$28,068
% Change-6.44%

Oddly enough this investor identified two winners, but still ended up with a net loss due to HABT's -40.7% return.  Johnson & Johnson had a very respectable return over one year with an 18.1% gain. That handily beats the historical expected return of the S&P 500 Index of approximately 8%.  Sadly the small gain from KO was not enough to offset the large loss and this investor ended up down -6.44% for the year.

What if you decided to purchase Exchange Traded Funds(ETF's) to gain exposure to these stocks instead? There are plenty of ETF's to give you exposure to almost every market niche.  Here is a respective ETF each belongs to along with their current weighting in the fund.

Habit Restaurants - BITE(1.98%)
Johnson & Johnson - PPH(5.5%)
Coca Cola - XLP(8.87%)

Since HABT is a smaller company it represents a proportionally smaller part of this ETF it belongs to. Let's take a look at an equal $10k investment in each ETF for the same time period.


BITEPPHXLPTotal
Starting Value$10,000$10,000$10,000$30,000
1 Year Performance2.5%-18.31%8.49%
Ending Value$10,250$8,169$10,849$29,268
% Change-2.44%


In this scenario the investor once again had two winners(BITE & XLP), but one loser with PPH.  The loss sustained by the ETF holding JNJ stock had a mirror opposite drop of -18.31% compared to JNJ's gain of 18.1%. The ETF holding HABT was much more stable compared to owning shares of the company outright.  The defensive oriented Consumer Staple XLP ETF is the only one showing a gain in both the stock and fund.

Overall this investor lost -2.44% of their money over the course of one year with their ETF strategy versus the -6.44% loss investing directly in stocks.  It's not comforting to know neither strategy produced a gain.  This is the risk of investing in specific stocks and sectors versus a broad based index.  

Speaking of the index. Investing in an S&P 500 Index fund such as SPY or IVV would have netted you a 4.24% gain during the same time frame.

So what's the average Jane & Joe to do?

That's a question entirely up to you with what you feel comfortable with.  If you are willing to take extra risk maybe going the route of single stocks might be for you. If that idea makes your stomach churn and the sound of broader diversification is music to your ears then maybe broad based ETF's are better suited.

I always ask myself a lot of questions before I hit the buy button on a particular company or ETF.  The lists are not all inclusive, but they should be a good starting point for the average investor just starting out.


Stocks
1. Buy a company with a long history of success
2. Buy a company that sells a product/service that is not easily replicated by others
3. The company established a wide moat with brand power
4. The company has outperformed it's peers or index
5. The company consistently generates above average margins

Remember this isn't an all inclusive list that I utilize to make purchases of individual companies. But it helps me weed out the weaker choices to focus on the best companies available.

For ETF's here are 5 guidelines that I use when deciding to make a purchase.

ETF's
1. Is there a reason to believe additional exposure to a sector is warranted?
2. Is the sector trading at a premium or discount to the overall market?
3. Does the sector offer a long term technological advantage, or geographical advantage?
4. Buying the ETF will allow me to significantly reduce Single Stock Risk in a riskier sector.
5. Is the expense ratio reasonable?

Notice the questions have a similar feel in some instances, but can be distinctly different. When purchasing ETF's you are more concerned about an overall trend and risk management. That's not to say we aren't managing risk when we buy individual companies.  We try to minimize that risk by making sure we only purchase great companies in acceptable proportions for our portfolio. Either way if you are buying a specific sector you are more or less looking to gain more exposure to it than you otherwise get with a broad based index ETF.

The last guideline for ETF's might be confusing if you are not familiar. Since a company runs the fund they incur expenses for compliance, payroll, etcetera. These are real costs.  The expense ratio is the percentage of assets the fund charges to manage the fund versus the overall fund value. The lower the ratio the better. Now these costs are in a way hidden from you by virtue that the funds are never taken from your personal investment account to run the ETF. When the fund needs to pay for expenses it takes fund assets to do so. This results in your share holding less assets, and is accordingly reflected in the share price as costs are passed on it is reflected by small changes in the ETF share price. Personally I try to shoot for 0.50% or lower for a passive fund and 1% for an active fund.


Overall I hope this helps the beginner to average investor make a little more sense out of their investing options. 


*10/30/2015 -10/31/2016

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