Why buy a car when you can own a dealership? The majority of investors would be better advised to buy an unmanaged exchange-traded fund (ETF) rather than investing in the securities of individual companies, according to Warren Buffett, a man generally recognized as the most successful stock investor in modern times. When asked what market advice he would give an individual in his 30s, Buffett said, “I would just have [my investment] all in a very low-cost index fund from a reputable firm…and I could just go back and get on with my work.”
Why? An investment in an ETF requires less effort, less research, less diligence, and encompasses less risk, and is likely to give you a better return on your investment than most managed portfolios.
Pitfalls of Individual Stock Investing
Individuals generally save portions of their current income to ensure they will have sufficient funds for an expected future expense, such as the purchase of a home, the education of children, retirement, or an unforeseen financial emergency. The amount of funds available in the future depends upon the combination of the proportion of current income diverted to savings and investments, as well as the earnings on those investments. Simply put, investing more and receiving a higher return on your investments will result in a greater sum of available funds in the future.
While investing in individual stocks has been promoted for years for its greater return compared to other investment vehicles, that strategy has been questioned by a number of investment advisers for the following reasons:
1. Superior Returns Are Unlikely
According to Francois Rochon, president of the wealth-management firm of Giverny Capital, “Most investors – professionals or not – can’t beat the market.” The efficient market hypothesis suggests that individual stock prices reflect all information known about the companies, so that there is no gain from “going to the trouble of gathering it.” While some academicians have challenged this with behavioral finance theory, most economists have suggested that trying to beat the market is a fool’s errand for everyone, particularly for amateur, part-time investors.
2. Investing in Individual Stocks Is Expensive
Commissions received on the purchase and sale of individual securities are the foundation upon which Wall Street rests. Even though the average commission rate has fallen per transaction, the increase in the total volume of transactions has more than replaced any lost revenues. Average daily volume on the New York Stock Exchange in 1970 was 11.6 million shares; by 2009, average daily volume had grown to more than 2 billion shares. It has been estimated that the commissions reduce the average annual return on a typical investor portfolio by 0.67%, a considerable penalty when you consider the average annual return for the New York Stock Exchange for the past 10 years has been 4.18%.
3. Maintaining a Portfolio of Individual Stocks Is Time-Consuming
Malcolm Gladwell’s book “Outliers” suggests that becoming an “expert” at anything requires 10,000 hours of effort and practice. The time required to continuously identify, research, and determine whether a security should be purchased, sold, or held in a portfolio can easily take 10 hours or more per week. People who are engaged in a career, being a good spouse, raising a family, and being active members of a community rarely have free time to dedicate to their investment portfolio.
4. Active Investing Encourages a Short-Term Focus With Negative Consequences
Humans have a psychological aversion to taking a loss or admitting error. This trait is reflected in our tendency to sell rising stocks too quickly and keep falling stocks too long, resulting in smaller gains and larger losses. As a consequence, individual investors are constantly debilitating their portfolios, eliminating those companies with the greater potential whose shares are rising in value in favor of retaining investments in companies whose shares are falling in value.
Benefits of ETF Investing
An exchange-traded fund is a pool of unmanaged securities that have been assembled to reflect the performance of a stock index (such as the DJIA or NYSE), a commodity, or the securities of those companies in a specific industry. The shares of the ETF trade like a stock – you can buy, sell short, use margin, purchase in units of one share, or buy and sell options.
The price of the ETF unit is set by market supply and demand. However, discrepancies between the price and the underlying value of the individual securities making up the index are instantaneously identified and eliminated by large professional trading groups with the assistance of powerful computer hardware and sophisticated software. Practically speaking for individual investors, the ETF always reflects the value of the index.
Investing in an ETF is easy, doesn’t require constant attention, and is less stressful for most investors. Just like stocks, ETFs trade continuously all day, and are especially attractive for an investor who believes that consistently beating the market is not possible, wants to invest in a single industry, or perhaps prefers to invest exclusively in companies of a particular country. He or she may prefer securities of those companies whose securities are less volatile than the industry as a whole, or in companies tied to the price of a specific commodity such as oil or gold.
There are ETFs for large U.S. companies, small ones, real estate investment trusts, international stocks, bonds, and even gold. Yahoo! Finance lists 1,440 ETFs available, with enough variety to satisfy the most demanding investor.
An investment in ETFs is recommended for most investors for the following reasons:
1. Research and Selecting an ETF Investment Requires Little Time
Investing in the shares of an individual company requires considerable diligence to find, review, and digest minimal information about the company – specifically the potential and risks of the company’s market strategy, the ability of its management to implement the strategy, as well as the strength and likely responses of its competitors. On the other hand, it is easy to find expert opinions and voluminous data on the general economy and its prospects, or the likely impact of the economy on a particular industry.
For example, one might easily surmise that healthcare will be the focus of government attention and investor interest for at least a decade, due to the need of the industry to remake itself for the future. In other words, it’s easier to hit the bigger target (the industry) than the small bull’s eye (a company within the industry).
2. Management Fees of an ETF Are Less Expensive
Prudent investors, including mutual fund advisors and sponsors, diversify their stock portfolios by holding a minimum of 8 to 10 securities simultaneously. But purchasing and selling individual stock positions is expensive, as are the management fees you might pay to an advisor. In fact, some private advisors take a percentage of the profits.
Unmanaged ETFs, on the other hand, have a low annual management fee usually between 0.5% and 0.9% of the funds invested, well below the fees charged by most mutual funds or other managed portfolios. This makes them ideal for a long-term, buy-and-hold investor, a strategy which has proven to be successful over the years.
3. Investment Expertise or Constant Attention Is Unnecessary
If you have access to a news station or The Wall Street Journal, you can easily determine the value of your investment. Of course, since you have a portfolio that reflects the performance of an index rather than a particular security, the volatility of your investment will be much less than the typical stock buyer. Therefore, you won’t experience the same stomach-churning, sleep-deprived moments of the typical security investor, nor the need to constantly check on your investment.
As a former investment advisor, CFP, and securities representative, I recognize that no single investment type or strategy is ideal for every investor, nor a guarantee of future success. However, in my 40 years of investing experience, I have seen few investors consistently exceed or equal the average return of the DJIA or the S&P 500 over a period of years. For that reason, I generally recommend an investment in an unmanaged ETF without reservation.
If you are one of those rare people who have the expertise, time, and nerves to invest directly in the equities of individual companies, I hope you will follow the stock investing survival techniques identified by Mr. Buffett at a Berkshire Hathaway annual meeting.
What are your thoughts on unmanaged ETFs?