Stock vs. ETF: Which Should You Buy
Perhaps you have decided that you want to invest in a particular sector. Now, you might be in the situation of picking between buying stocks or an exchange-traded fund (ETF).
Deciding between stocks or an exchange-traded fund is no different from any other investment decision. As usual, you need to search for ways to reduce your risk. And of course, you want to generate a return that beats the market.
Lessening the unpredictability of an investment is the general method of mitigating risk. Most investors give up some upside potential to avert a potentially catastrophic loss. An investment that offers diversification over an industry group ought to lessen the portfolio's unpredictability. This is one way that diversification through ETFs works in your favor.
Alpha is the capacity of an investment to beat its benchmark. Anytime you can mold a more stable alpha, you will be able to experience a higher return on your investment. There is a general belief that you should possess stocks, instead of an ETF, to beat the market. In addition, many investors are under the impression that if you buy an ETF, you are stuck with receiving the average return in the sector. Neither of these presumptions is necessarily true because it depends on the characteristics of the sector. Being in the right sector can lead to achieving alpha, as well.
When Stock Picking Might Work
Industries or situations where there is a wide dispersal of profits – or cases in which ratios and other forms of fundamental analysis could be used to spot mispricing – offer stock-pickers an opportunity to exceed expected returns.
Based on your research and experience, possibly you have some knowledge of how well an organization is performing. This insight gives you an advantage that you can use to lessen your risk and accomplish a better return profit. Good research can create value-added investment opportunities, rewarding the stock investor.
The retail business is one group in which stock picking may offer better opportunities than buying an ETF that covers the sector. Organizations in the sector tend to have a wide dispersion of profits based on the specific items they convey. This may create an opportunity for the insightful stock picker to do well.
For instance, suppose that you recently noticed that your daughter and her friends favor a specific retailer. Upon further examination, you discover that the organization has upgraded its stores and employed new product management staff. This led to the recent rollout of new products that have caught the eye of your daughter's age group. So far, the market has not taken note. This type of perspective (and your examination) may give you an edge in picking the stock over purchasing a retail ETF.
Organization insight through a legal or sociological perspective may provide investment opportunities that are not immediately captured in market prices. When such an environment is determined for a specific area where there is a lot of return dispersion, single-stock investments can give a better profit than a varied approach.
When an Exchange-Traded Fund (ETF) Might Be the Best Choice
Sectors that have a tight dispersion of profits from the mean don't offer stock pickers an advantage when attempting to produce market-beating returns. The performance of all organizations in these areas tends to be similar.
For these sectors, the overall performance is fairly similar to the performance of any one stock. The utilities and consumer staples businesses fall into this category. For this situation, investors need to choose the amount of their portfolio to allocate to the sector overall, rather than pick specific stocks. Since the dispersion of profits from utilities and consumer staples tends to be narrow, picking a stock doesn't offer a better profit for the risk that is inherent in owning individual securities. Since ETF’s pass through the dividends that are paid by the stocks in the sector, investors receive that benefit as well.
Often, the stocks in a specific sector are liable to disperse returns. However, investors can't choose those securities which are likely to continue outperforming. Therefore, they can't figure out how to bring down the risk and improve their possible returns by picking one or more stocks in the sector.
If the drivers of the performance of the organization are hard to comprehend, you should seriously consider the ETF. These organizations may have complicated innovations or processes that cause them to fail to meet expectations or do well. Perhaps, their performance relies upon the fruitful development and sale of new, unproven technology. The dispersion of profits is wide, and the chances of finding a victor can be very low.
The biotechnology business is a genuine model, as many of these organizations rely upon the fruitful development and sale of a new drug. If the development of the new drug does not meet expectations in the series of trials (or the Food and Drug Administration (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.
Certain items and specialty technology groups, such as semiconductors, fit the category where ETFs might be the favored other option. For instance, if you believe that now is a good time to invest in the mining sector, you may want to gain specific industry exposure.
Nonetheless, suppose you are worried that a few stocks may experience political issues that could hinder their production. For this situation, it is wise to buy into the sector, as opposed to a particular stock, since it lessens your risk. You can still benefit from growth in the overall sector, especially if it outperforms the overall market.
The Bottom Line
When choosing 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 profits from the mean. Moreover, with stock-picking, you have the ability to gain an advantage by using your knowledge of the industry or the stock.
ETFs offer advantages over stocks in two circumstances. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF may be the most ideal choice. Second, if you are unable to gain an advantage through knowledge on the organization, an ETF is your best choice.
Regardless of whether you are picking stocks or an ETF, you have to keep updated on the sector in order to comprehend the underlying investment fundamentals. You do not want to see all of your good work go to waste as time passes. While it's imperative to do your examination so you can be able to pick a stock or ETF, it's also critical to research and select the broker that best suits you.