stocks vs etfs

Stocks versus ETFs

If you ask ten investors Stocks vs ETFs, which is better you’ll probably get a few different answers. The first issue to think about is what kind of return do you want to achieve and how much risk are you comfortable with.

As anything else they have their advantages and disadvantages so how do you pick your side? That’s what I intend to cover in this article.

Media coverage: Stocks vs ETFs

If you search for stocks to invest in you’d be bombarded with all sorts of promising dividend stocks, growth stocks, blockbuster stocks, the next Google and so on.

You may also find a lot of articles that claim that ETFs and diversification are for uneducated people who don’t understand the stock market. I find that counterproductive as we all start somewhere and then learn.

Unfortunately whenever you read something like these stocks will make you a millionaire you are just looking at someone’s opinion. It doesn’t mean anything other than that the author thinks a certain way about some company.

Think about it, there are thousands of articles like that yet I haven’t seen that many people become millionaires after reading them. I have however seen a lot of people retire on a private pension.

Maybe it’s my own observational bias. Here, at The Stocks and Options Spot, we don’t take sides and look at things from different angles. The only wrong way of doing it is if you are constantly losing money. So you have to know that any stock market investment can lead to losses.

What happens when you buy stocks

You can make a ton of money from an individual stock. There is no argument about this.

Big winners

All we have to do is to look at some historical examples. Microsoft was $25 in 2010 and it is now trading for $215. American Airlines was $2 in 2013, after emerging from bankruptcy, and is now trading for $13.

It is similar when it comes to UK shares. Boohoo was trading for 25p in 2015 and has soared to £3.50. Diageo has performed well too, trading at £27 compared to £11 in 2010.

The list goes on and on and on, you can find thousands of examples in any industry, except maybe VHS rental. I haven’t even mentioned Amazon, Google or Lululemon.

Single stock risk

Investing in a single stock is one of the riskiest investments available. There are others which are even more risky like venture capital and selling naked call options among others. However, if we concentrate on the main investment vehicles, stocks, ETFs and bonds, the shares carry the highest risk.

You never know what could happen to an individual company. Listed companies are more transparent compared to private ones. However, you still have no idea what is going on inside.

Prominent examples are Wirecard and Luckin Coffee which were involved in fraud.

Market and industry risks

Sometimes a whole industry becomes obsolete, like film cameras in the case of Kodak. Other failures may involve the evolution of an industry, for example the switch from product to platform in mobile phones which hurt Nokia.

A market crash is always a possibility, statistically speaking once every 8-12 years. Check out the performance of Cisco Systems before and after the dot-com crash.

One of the characteristics of a crash is that it is unpredictable. Otherwise it will be prevented one way or the other. You never know who’s turn it is to go down, it was tech in 2000, then banks in 2008.

The market is prone to bubbles which can be difficult to identify while you are living in one. I assume you’ve watched the Matrix and you understand the reasoning.

Business risk

A company can just be unlucky or customer demand may change, their management could be less than brilliant, a big project may fail, the firm’s culture could bring it down or some other reason can lead to failure.

It’s unpredictable

The point is that you can’t predict the success of an individual stock with a high level of accuracy.

I ran an experiment a couple of years ago. I picked up 20ish US stocks recommended by 5 star analysts and put them in a virtual portfolio. All of them were expected to outperform the market soon. The analysts were all very smart people with a published success rate of 75-85%.

I left the stocks alone for about a year and guess what happened. The portfolio performed very poorly compared to the benchmark (the S&P 500 index). Then you start to ask yourself why bother, I could have just bought SPY (an ETF) instead.

This brings us to the next part of Stocks vs ETFs, the funds.

What is an ETF

An exchange traded fund is a basket of stocks or other securities which exists for different reasons. ETFs are just as accessible as stocks.

Index tracker ETFs

When you hear on the news that the stock market is up or down the journalists refer to the performance of indices. You can’t buy an index like the S&P 500, FTSE 100 or the DAX directly.

You’ll need to buy index futures which are a derivative, hence not suitable for long term investing. The other option is to buy all the stocks that form the index in the same proportion which is not a practical solution for most of us on the retail side.

Instead you can buy an index ETF which holds all the necessary stocks. These ETFs are the meaning of passive investing, you buy them and then forget about it.

Country and region ETFs

Nowadays, you have it all. You can invest in Africa, Asia, France or anywhere else by purchasing an ETF denominated in your own currency. However, it is important to know that you expose yourself to currency risk. You could buy a currency hedged ETF but this costs money thus you sacrifice profits.

For example, if you are investing in Japan and the yen weakens against the pound you will lose money even if the stock doesn’t move at all. This is because after the yen drops in value you can buy more stock with the same amount of pounds.

Conversely, you can make money if the yen gets stronger as the stock you own will be more expensive in pound sterling. So make sure you check what is the trend of the exchange rate prior to any purchases.

Sector ETFs

You may want to invest in a given sector, like retail or technology, but you are not sure which companies to pick or you want to invest in multiple companies. Instead of buying Barclays, Lloyds, Santander and NatWest shares you may choose to buy a Banking ETF instead.

There are some stocks which are very expensive. I’d need to fork out quite a bit to buy 10 shares of Google and Amazon, about $50,000. What if I want to invest £1,000? A technology ETF will let me get the exposure and abide by my budget.

If there is a market crash there will be a sector which is the hardest hit. Currently it’s travel, hospitality, brick and mortar retail and the like. These may take a long time to recover.

You probably know that banks had it hard in 2008. XLF, a financial sector ETF, recovered in 2017. That’s a lot of waiting for nothing. XLK, a technology ETF, took even longer to recover from the 2000 dot-com crash, a whopping 17 years! Unfortunately an ETF doesn’t give you a guarantee that you’ll make money.

You can reduce the risk by investing in a few sectors which brings us back to broad market index ETFs as they achieve the same goal.

Derivative ETFs

Futures ETFs

There are some products which are difficult to access as a retail investor due to their size. For example, I had my eyes on a certain bond a few months ago but the minimum trade size was £100,000 so I was priced out.

The same is true for other products like the VIX or oil futures. A single oil futures contract is worth around $40,000. There are funds which offer these at an affordable price in case that you want to speculate.

Leveraged and inverse ETFs

Leveraged ETFs aim for a multiplier of the return of a given benchmark. For example, if you think the S&P 500 is going up today you can buy a 2x or 3x fund and if you’re right you’ll get 2x or 3x the return. Similarly, if you want to short sell the index you can buy an inverse -1x, -2x or -3x ETF.

I wouldn’t recommend to use these unless you have a strong conviction about the outcome. The reason is that they hold complex derivative products and you can quickly end up out of pocket.

Complexity of the derivative ETFs

The derivative products composition of these funds may not be apparent to some retail investors.

One prominent example is the United States Oil (USO) fund. Novice investors may think that they are investing in oil while the reality is that they are speculating on the price of front and back month oil futures.

Therefore, I’d strongly suggest to avoid any derivative based ETFs and exchange traded notes (ETNs) if you are unfamiliar with the meaning of term structure, contango, backwardation or credit default swap.

You can always learn and buy these once you are ready to speculate if that’s what you want. If in doubt always check the brochure of the ETF to understand what you are getting yourself into.

Management style

ETFs are available as index funds and active funds. This allows you to pick whichever side you want.

If you feel that the market itself is performing well enough you can just buy a low cost index fund. You know that you’ll get the same as the gains or losses of the index.

However, you may want to invest in an active fund. Active management is suitable for situations where you need feet on the ground, like emerging market stocks for example.

You need to be aware that active management has not delivered any outsized returns in recent years.

ETFs give you options

Socks versus ETFs is a difficult topic as it is perfectly fine to make your own portfolio of stocks. The advantage of ETFs is that they make this process easy for you.

They also give you access to a lot of instruments which you wouldn’t be able to buy. If you are brand new to investing you are probably already confused by the amount of ETFs available so let’s compare them with stocks.

Stocks vs ETFs: Diversification

We already found out that the main advantage of stocks is that the return can be eyewatering. However, we have to balance that with the risk of a 100% loss.

The most popular way to reduce risk is diversification. This is exactly what you are doing when you buy an ETF. Here’s a graph from another article I wrote to visualise how it works:

You are looking at the yearly performance of a portfolio of the S&P 500 and a bond ETF over the last 5 years. The vertical axis represents the return and the horizontal one represents the risk. Bonds only deliver 6.52% return while stocks alone achieve 12.75%. Each step, for example 6.83% removes 5% bonds and adds stock so you get 95% bonds and 5% stock, then 90%:10% and so on until 12.43% return where we have 95% stock and 5% bonds.

The purpose of this is to reduce the risk while maximising the return. In this example we mix stocks and bonds to see how much bonds we need to offset some risk.

The result is that if we use 15% bonds and 85% stock we sacrifice 7.9% of the return of a pure stock portfolio (by achieving 11.81% instead of 12.74%) but we also reduce the risk by ~22.5% (from 15% to just over 12%). In fact the risk is about the same as a 100% bond investment which would only deliver 6.25% return.

This example does not include reinvestment of the dividends received.

Advantages of Stocks vs ETFs

The reason that diversification is frowned upon is that instead of getting say $1,000 return from stocks in the example above we reduced that to $921 by adding bonds. Similarly, if you bought a single blockbuster stock like Tesla in 2015 you would have made 883%.

Compare that to a total return (dividends reinvested) S&P 500 UK ETF for the same period: 121%. That’s an average of 24.3% per year compared to Tesla’s 176.6%. If we diversify the S&P 500 fund with 15% bonds we’d chip away some of the upside so we get around 22%.

This is why stock picking is popular. Some investors try to buy a few blockbuster stocks and get a huge return.

Advantages of ETFs vs Stocks

The disadvantage of single stocks is that they can underperform or the company can go bust. Enron for example was a massive success before it went bankrupt and investors lost their money. This can never happen to you if you invest in an index tracking ETF.

I already gave examples of successful stocks. Now let’s look at the downside.

Share price may go down and never recover

General Electric had 3 peaks at $50, $40 & $30 and it is now trading for $6.84. Is it going to make a come back? No one knows. Bank of America traded for $50 at its peak and never recovered after the financial crisis of 2008, it is now $25. Hertz are going bust and currently trading around $1, down from a peak of $50.

Here in the UK you have Rolls Royce which was £11 at its prime and is now just over £2. British Petroleum did better as it only went down from £6 to £2. Imperial Brands went down from £40 to £13.50.

Unintended diversification and underperformance

Normally a portfolio will consist of a few stocks. You picked 15 future winners and now you wait. Inevitably, some of these will turn out to be duds which is fine.

However, they will drag down the performance of your portfolio and you may end up underperforming and index ETF. This is exactly what happens to finance professionals who do this for a living.

If you venture on the internet you’d find examples of epic trades that turned tens of thousands into millions. These are real but rare so the probability of success is low. This is the case with any other venture.

All outlier events related to stock market returns, unicorn start-ups or rapid accumulation of wealth are rare by definition as I previously discussed here.

Of course we should keep trying! However, it is always worth to be aware of the risks. You can’t win if you blow your account and are out of the game.

Performance of broad market ETFs

There are some really straightforward ETFs like SPY and VOO. You get exactly what you were promised at an annual cost of 0.09% and 0.03% respectively. I think that it can’t be any cheaper than that considering the fund does everything for you.

Both of these funds track the performance of the S&P 500. Check out the chart of the index and the ETFs below, it’s a perfect match.

The only downside is that if the index underperforms your ETF underperforms too. I already discussed single stock risk and I said that you can’t lose all of your money if you buy an ETF.

This is true, however, you can still lose money from an index ETF regardless of how long you wait. Check out the chart below to see what happened to Japan’s Nikkei 225:

It crashed at the end of 1989 and never recovered. The people who bought it at the peak would have recouped some of the losses from dividends over time. They could have also accumulated more of it at a cheaper price to reduce their cost basis.

I’m not sure that Japanese investors could have mitigated the losses by choosing stocks vs ETFs.

But the problem with that line of reasoning is that everyone invests with a goal in mind. No one has an unlimited time horizon, otherwise we could wait another 30-40 years to see if it will rebound.

The unpredictability of future performance is real regardless of any stocks vs ETFs arguments.

Stocks vs ETFs: Conclusion

I hope that this article didn’t just make you feel even more confused about ETFs. Unfortunately there is no sure way of making money.

Each investment vehicle has its positive and negative sides so there’s nothing bad about investing in a few different things.

Nevertheless, it is important to note that you can over diversify. You will probably do better if you carefully select a few ETFs that fit your needs rather than buy everything under the sun.

The same is the case with stock. If you think that a given stock is going to the moon you just have to include it in your portfolio.

If you are seeking very high return then you’d need to buy a few stocks or trade derivatives. But you have to be careful because the risk will be very high too, you can blow your account. Moreover, if you buy too many stocks you’ll end up with the average market return or less.

As always, do your research, do the math and invest the way which fits your goals.