ETFs have been widely touted as the ideal investment for many retail investors: easily accessible, low cost, low maintenance and diversification (dependent on which ETF). There’s even the famous ten-year bet by Warren Buffet between low cost, diversified ETFs and actively managed hedge funds. Buffet won. So why do I pick stocks over dumping it all in an ETF?
Beating The Market
My goal is to beat the market by more than 5% per year over ten years or more. This can only be achieved through active management of your portfolio. By managing your own portfolio, you have control over your own investments.
The statistics are against me, but that will not stop me from trying. The knowledge gained from doing research, looking through annual reports, looking at your portfolio tank through a recession, etc will help me grow as a person.
One argument for picking stocks is that you grow as an investor. After many hours of looking at financial statements, annual reports, etc, you will get better at evaluating companies (at least, that’s the idea). This should provide you with a high return of investment on your portfolio.
The downside of simply dollar cost averaging into an ETF is that you do not learn anything. For some people (don’t like reading through annual reports, finance is boring, etc), that is perfectly fine. There are many other ways of increasing income.
Lower Initial Risk
At the start of your investing / FIRE journey, your portfolio will be smaller than at the end. This means that investing mistakes are less costly at the start. A 50% mistake at $10,000 is $5,000. A mistake at $100,000 is $50,000. A mistake at $1,000,000 is $500,000. The cost of a mistake scales according to your portfolio size; if you want to ‘experiment’, do it at the start of your journey.
When your portfolio size is small, the growth of your portfolio is affected more by your capital injections (savings) than investment returns. A portfolio size of $100,000 means that an injection of $20,000 is an increase of 20%. Even if the market crashes by 20%, your portfolio size is not affected because of your savings.
Your absolute returns scale according to the size of your portfolio. This follows the same principals from the previous point. Once you are many years into your FIRE/investing journey, your portfolio should (hopefully) be relatively large. This means that improving your annual returns by a small percentage increases your absolute return by a sizable amount.
With a portfolio of $1 million, increasing your returns by 1% means an extra $10,000 every year. Of course, this works the other way too, as taking on too much risk could mean that you lose a large portion of your portfolio. We have to mitigate these risks when a large proportion of your net worth is in equities.
Picking stocks is inherently more risky than buying an ETF. This means that you have to mange your own risks when investing.
The main point of diversification is to prevent a case where all your eggs are in one basket. If you are 100% in equities and the stock market crashes, your portfolio value may drop by half. If you diversify by buying some bonds, your portfolio may not drop as much.
There are a few ways you can diversify. Firstly, you can split your portfolio between different asset classes, such as equities, bonds, real estate, commodities, etc. One of the more common ways to diversify in the FIRE community is a split between equities and bonds. For example, an 80% equities, 20% bonds split.
If you are investing in equities, you can further diversify between different levels. They are: company, sector/industry and country. I am currently diversifying between sectors but not country since my portfolio is still relatively small. However, I am looking to invest in overseas companies in the future and set up trading accounts in anticipation of this.
As a side note, another reason to diversify in Singapore is that the market volume in SGX is small.
I take a long term view of investing. The way I think of it is: I will invest money only if I do not need it for at least ten years. Any money in my portfolio will not be touched. This means that an emergency fund is needed to cover any financial disasters.
Having an emergency fund gives me a peace of mind and ensures that I do not need to touch my portfolio in case of emergencies. I also have insurance to cover any extreme cases that cannot be covered by the emergency fund.
Echo Chambers and Groupthink
When picking stocks, you might come across forums, chat groups, blogs etc that are bullish/bearish on certain companies. There is a danger that groups with people that have all the same perspective just repeat the positives and ignore the negatives of a company/sector. This might blind them to the shortfalls and threats to the company, and not have a balanced view of the company they are investing in.
I prefer to have an objective valuation of a company. Whenever I intend to invest in a certain company, I try to find as many negative things about the company as possible. Then, I will only invest after evaluating both negatives and positives.
As the sole manager of the portfolio, only I know why I bought the companies, exit strategies, etc. This means that if anything were to happen to me, no one would know what to do with the portfolio. It will most likely be liquidated. If you have dependents that rely on the portfolio on income, they may not know how to manage the investments. Even worse, they may squander the money away.
Therefore, you need to have a plan in place to handle this situation. It would depend on your circumstances. If one of your dependents are financially savvy, you could explain your investment thesis to them. You can also have a regularly updated document about your investments and exit strategies. If there is no one able to do that, one way is to set up a trust.
Personally, my portfolio is relatively small, so I am fine with it being liquidated. However, when it grows larger, I will reevaluate my options.
Investing is uncertain: I do not know if I can beat the market even though the initial results are promising. I will give myself between 3 – 5 years and see whether I will continue picking my own stocks or just dump every thing into an ETF.