Should You Buy Stock Or An ETF?
Whether to buy the stocks or the ETF? This is one question that Investors encounter every day. Many are under the impression that if you buy an ETF, you are stuck with receiving the average return in the sector. This is not necessarily true, depending on the characteristics of the sector.
Making this choice is no different from any investment decision. As always, you want to look for ways to reduce your risk. Of course, you want to generate a return that beats the market.
When deciding whether to pick stocks or select an ETF, look at the risk and the potential return that can be achieved. Stock-picking offers an advantage over ETFs, when there is a wide dispersion of returns from the mean. And you can gain an advantage using your knowledge of the industry or the stock.
Reducing the volatility of an investment is the general method of mitigating risk. Most rational investors give up some upside potential to prevent a potentially catastrophic loss. An investment that offers diversification across an industry group should reduce the portfolio volatility an investor is exposed to. This is one way that diversification through ETFs works in your favor.
Industries or situations where there is a wide dispersion of returns, or instances in which ratios and other forms of fundamental analysis could be used to spot mispricing offer stock-pickers an opportunity to exceed.
The retail industry is one group in which stock picking might offer better opportunities than buying an ETF that covers the sector. Companies in the sector tend to have a wide dispersion of returns based on the particular products that they carry, creating an opportunity for the astute stock picker to do well.
For example, recently, you have noticed that your daughter and her friends prefer a particular retailer. Upon further investigation, you find that the company has upgraded its stores and hired new product management people. This led to the very recent roll out of new products that have caught the eye of your daughter’s age group. So far, the market has not noticed. This type of perspective (and your research) might give you an edge in picking the stock over buying a retail ETF.
When an ETF Might Be the Best Choice?
Often, the stocks in a particular sector are subject to disperse returns, yet investors are unable to select those securities which are likely to continue over-performing. Therefore, they cannot find a way to lower risk and enhance their potential returns by picking one or more stocks in the sector. (To determine how to pick ETFs, read Five Ways to Find a Winning ETF.)
Sectors that do have a narrow dispersion of returns from the mean do not offer stock pickers an advantage when trying to generate market-beating returns. The performance of all companies in these sectors tends to be similar. For these sectors, the overall performance of the sector is fairly similar to the performance of any one stock. In this case, investors need to decide how much of their portfolio to allocate to the sector overall, rather than pick specific stocks. Since the dispersion of returns from utilities and consumer staples tends to be narrow; picking a stock does not offer sufficiently higher return for the risk that is inherent in owning individual securities. Since ETFs pass through the dividends that are paid by the stocks in the sector, investors receive that benefit as well.
If the drivers of the performance of the company are more difficult to understand, you might consider the ETF. These companies may possess more difficult to evaluate technology or processes that cause them to under perform or do well. Perhaps their performance depends on the successful development and sale of a new unproven technology. The dispersion of returns is wide, and the odds of finding a winner can be quite low. The biotechnology industry is a good example, as many of these companies depend on the successful development and sale of a new drug. If the development of the new drug does not meet expectation in the series of trials, or the FDA does not approve the drug application, the company faces a bleak future. On the other hand, if the FDA approves the drug, investors in the company can be highly rewarded.
ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, and regardless of return dispersions, an ETF is your best choice.
Conclusion
Whether picking stocks or an ETF, you need to stay up to date on the sector or the stock in order to understand the underlying investment fundamentals. You do not want to see all of your good work go down the drain as time passes.
Picking Individual Stocks over ETF is always not the easiest of decisions.
Very rightly said in this article, that stocks becomes the best pick only when the investor has noticed a development in the stock before the market (majority) can notice. As per this you can buy low, and when market picks up you sell at high. But cricial is to identify the development before others.
ETF’s can be the choice when even after reading the finacial statements nothing worthwhile cannot be noticed. Means an investor is not sure whether the price will go up or not. In this case let the ETF manager do the hardwork and manage your money.