Stocks vs ETFs – Which Route Should You Take?
While there is no direct answer to this question, in this post, we consider whether picking individual stocks is worth the additional risk compared to buying a well-diversified ETF
I have been thinking quite a bit about this question in recent years, and even more so in recent months, as I had to fully restructure my portfolio and wanted to set it up as a buy-and-hold retirement (in about 35 years) portfolio. Would I be better of with individual securities or ETFs today?
I know this might seem like an odd question for someone like me. I analyze stocks and the companies behind them almost every day, so why would I even consider an ETF, right? On many occasions, ETFs are seen as a great alternative for those who simply don’t have the time or the knowledge to analyze stocks and monitor them.
While this is true to some degree, in reality, it isn’t that simple, and ETFs can be a valuable consideration for many more reasons, including for active investors, no matter your time horizon.
Fun fact: even Buffett’s Berkshire owns two S&P500 ETFs.
You see, ETFs, or Exchange-Traded Funds, are pooled investment securities that can be traded like individual stocks and have been growing rapidly in popularity.
These ETFs can be structured to follow anything from a commodity or benchmark to a specific sector or bonds. In the end, an ETF is just a basket of securities, allowing you to get broad exposure without having to pick out individual securities. They allow you to invest in a sector, country, or market without having to put in much effort. This is how Time explains it:
“In essence, an ETF can be likened to a well-diversified assortment of investments. For instance, an ETF may constitute of a blend of high-value stocks, municipal bonds, and exposure to precious metals. By purchasing shares of an ETF, investors obtain fractional ownership of the underlying investments, based on the specific composition of the fund.”
Large investment firms like Blackrock, State Street, or Vanguard generally manage and set up these ETFs, which charge you a small fee in exchange. For the most popular ETFs, this can be as low as 0.01% of your invested capital annually. For more details on the structure of ETFs, this page explains a lot.
Investing in ETFs has several benefits over investing in individual stocks or other securities. These include the following:
ETFs make it easy to gain exposure to different sectors, markets, or regions.
ETFs are more diversified as you are not investing in a single company but a basket of securities, which generally lowers risk.
Picking successful ETFs requires less effort compared to stocks. Picking out successful benchmarks or sectors is much easier than picking out successful stocks.
Simply put, investing in ETFs is less time-consuming, less risky, and incredibly convenient while still offering the same low barriers as investing in stocks.
However, there are also downsides to ETF investing compared to buying individual stocks. Most notably, investing in individual stocks generally has the potential for more significant returns. You see, ETFs are not designed to outperform the underlying benchmarks but rather to track.
While picking the right stocks can help you outperform the S&P500, buying an ETF tracking the benchmark will only allow you to perform in line, so for those looking for massive gains, multi-baggers, and consistent double-digit returns, ETFs rarely offer that – with higher risk comes the potential for higher reward.
In addition, as pointed out before, the ETF manager charges an annual fee for managing the ETF in question. By investing in individual stocks, you are the manager, avoiding these fees, which can be significant depending on your portfolio value and the exact fee. Positively, ETF fees have been trending down, so these are becoming less significant.
Overall, while stocks are a riskier investment, the return potential is greater if you are able to pick out the winners and avoid the losers, the fees tend to be lower, and you have greater control over what you own. And, of course, by buying companies with a great business model, solid earnings, and excellent management, and by diversifying your portfolio, you can keep risks lower, even when picking individual stocks.
So, what is the best way to go? Obviously, this is a very personal decision and depends heavily on your investing strategy and goals.
Nevertheless, let me give you some more background: How likely are you to pick the winners out of thousands of companies, properly decide when to buy and sell, and how likely are you to outperform a simple S&P500 ETF?
Good luck consistently outperforming the benchmarks – Why fight them if you can own them?
Let’s just be honest: Every stock picker aims to outperform the market. Very few spend time investing in individual stocks only to be satisfied with average mid-single-digit returns that just about beat inflation…
Yet, no matter how many investing books you read, how much research you do, or how much control you have over your emotions, outperforming the markets is a serious challenge, and only a few manage to do so consistently.
I have mentioned this in previous posts, but it is worth highlighting again that data shows that retail investors like you and me generally have trouble beating the market. In fact, the majority of retail investors lose money in the market.
Data shows that approximately 90% of retail investors underperform or even lose money in the stock market over the long run. Meanwhile, only 5% beat the S&P500 for three consecutive years.
The graph below says it all… the average investor barely manages to outpace inflation. Of course, this is not only due to retail investors struggling to pick winners; the underperformance is driven by many factors, like panic selling, following hype, etc., but it still says a lot.
Yet, this is nothing to be ashamed of, considering that active equity funds and fund managers mostly underperform the global indices. Barron’s explained that “over the past ten years, less than 7% of U.S. active equity funds have beaten the market.” Furthermore, CNBC reported that “almost 80% of active fund managers are falling behind the major indexes.”
Taking this over a 15-year horizon, this drops to 10% of large-cap fund managers; over a 20-year horizon, only 6% managed to outperform. Let’s just say that outperforming through stock picking is no simple task.
Further highlighting how hard it is to outperform the markets by picking stocks, there is the famous story of Warren Buffett placing a $1 million bet in 2008, claiming he would outperform most Hedge Funds by simply buying an S&P500 tracker.
Guess what? He beat them quite easily, with the index fund returning 7.1% annually by 2016, against just 2.2% on average by five hedge funds.
This shows us that picking individual stocks isn’t easy and that outperforming a simple tracker isn’t as straightforward as it might seem. Even the best of us must acknowledge that outperforming these benchmarks is challenging, so why try it?
According to Buffet, buying a tracker is simply the best, and considering what we discussed above, it's hard to argue against it. These are his exact words:
“In my view, for most people, the best thing to do is own the S&P 500 index fund.”
Indeed, data shows that over long-term horizons, the index tends to produce better returns than actively managed portfolios, especially after taking into account taxes and fees.
Does this mean simply owning an S&P500 tracker is a no-brainer? Absolutely not!
What all the data above shows us is that the idea that you have to buy individual stocks to achieve the highest returns isn’t entirely correct. Yes, individual stocks have a higher chance of delivering greater returns, but this does come with a high level of risk, and it turns out only a minority can properly pick out winners consistently.
Of course, this shouldn’t come as a surprise, considering the majority of stocks in the S&P500 underperform the index in any given year. In 2023, a whopping 72% fell short – good luck picking out the winners consistently.
As a result, it is hard to tell which of the two (stocks or ETFs) is the winner here, as both have their positives and negatives. It will really depend a lot on your investment strategy. However, at the same time, 99% of retail investors want to achieve the highest returns at the lowest risk (who doesn’t, really?), and going by everything discussed so far, for the general investor, a general ETF seems to be the best option, exactly as Buffett explained many years back.
Is there a default winning strategy here? Are you best off with either ETFs or Stocks? No, when investing in the stock market, there isn’t a default strategy for the most success, and there isn’t a direct answer.
What we can conclude is that for those looking to compound their invested capital steadily, with low risk, and without too much of a hassle, buying an S&P500 or all-world ETF is probably best. Historically, these benchmarks deliver high-single-digit to low double-digit returns (roughly between 8-10%), which is nothing short of solid. Inflation-adjusted, you are looking at compounded returns of 6-8% annually. For most, this should be able to help you reach your long-term financial goals without taking much risk.
Just buy, add over time, and don’t look back.
Personally, I like to combine both ETFs and stocks in the portfolios I manage, getting the best of both worlds. I tend to go with an all-world or S&P500 ETF as the basis of my portfolio to create a foundation for an in-line performance and to lower volatility, and like to add some ETFs focusing on specific markets or sectors for which I see a bright future (I very much like Healthcare and Semiconductors today), which ideally boost my returns but still manage risk.
Finally, I tend to hold several high conviction, higher risk, but also higher return stocks to top it off. These are always profitable and very high-quality stocks with great business models, a (future) leadership position, and terrific management.
For me, this offers an outstanding balance between risk and reward while not being overly time-consuming. Most importantly, the strategy has allowed me to outperform the S&P500, generally viewed as the one to beat, for four straight years.
I am not claiming this strategy is right for everyone, but it has worked perfectly for me.
If you want to see what my all-stock or ETF & stock portfolios look like, consider upgrading to paid and getting access to my monthly portfolio updates. If you’d like some ETFs to consider for those in the U.S. or Europe, let me know in the comments, and I will give you some suggestions.
Finally, a small announcement: To better play into the needs of both ETF and investors in individual stocks, in the future, I will start covering market and economic developments more often, and I will start covering and dissecting entire industries like semiconductors or FinTech to give you a larger overview of investment opportunities. This way, we expand our scope and hope to play into the needs and interests of all of you! Of course, we’ll also continue to cover and discuss many more great individual businesses
In the comments, let us know if you want us to cover any specific subjects, economic developments, or industries. Cheers!
great article, yes, I'd like some ETF recommendations, thanks
Really good article I personally invest in both but I strongly invest in the VTI from Vanguard