5 times Stock Picking is better than ETFs
There are 5 particular situations in which buying single stocks is better than buying ETFs.
ETFs and index funds are usually the best way to optimally diversify your portfolio and to avoid picking a stock that at some point falls off the sky. But this year I added quite a bit of single stocks to my portfolio and I thought of making this video because there are, indeed, some situations in which buying single stocks is a good idea for the average investor.
1. Market Crash
The reason number 1 is the good old market crash.
Basically what we’ve seen in 2022.
Peter Lynch, one of the most famous American investors and mutual fund managers, says that there’s only one thing you can know about the stock market, and that is “that it goes up and down”.
In a little over 100 years the market has crashed by more than 10% almost 60 times. Around 20 of these times, the market crashed more than 25%, the last one being because of the covid pandemic and again almost 25% last year.
So imagine, on average once every 5-6 years the market crashed by over 25%.
But just as some individual stocks grow faster than the market during bull market periods, the same stocks usually drop much stronger in times of crisis.
Take for example some big companies like google and amazon during the covid pandemic crisis in march 2020:
Crises often have little to do with the real financial results of single companies. It’s more of a domino effect given by the panic of people that start selling and keep selling for the fear of losing more.
So if good companies grow more than the market but then lose more during market crashes, during a market crash it might be a good idea to invest in some individual stocks of proven successful and financially stable companies.
Of course, you still need to analyze the companies and be sure they are going to keep growing, but you do have the advantage of seeing the history of the stock price in all the past years before the market crash. And you need to be careful about small companies because they could actually go bankrupt or struggle to recover from the crisis.
2. Price drops due to temporary, fixable issues
Number 2 are temporary, fixable issues.
Facebook had one of these bad incidents in 2018, when news broke that they allowed third-party developers, like British political consulting firm Cambridge Analytica, to access the data of more than 50 million users without their permission:
Cambridge Analytica was used by Donald Trump’s 2016 presidential campaign to target voters, so they also made the link with the Trump’s campaign. This scandal cost the reputation of facebook and the company’s stock price dropped 40% from its peak around July 2018.
Another example was when Volkswagen lied about the emission values of its diesel engines. In 2015, Volkswagen admitted to installing a software that significantly changed emission performance results in diesel engines sold in the United States. The company’s stock price tumbled by about 30% within days of the emissions scandal breaking.
So what do I want to say?
Corporations are run by people. As such, they are prone to make mistakes.
Whenever a big company makes one of these mistakes, usually the result is a huge drop in reputation.
Whether it’s a cell phone that overcharges and starts exploding, a failed marketing campaign, or the downfall of an important CEO of a company, several factors can cause a company’s stock to drop.
If you identify one of these situations in a company which otherwise shows sound financial numbers and the ability to survive such scandals, buying that company instead of an ETF might be a great opportunity to achieve great returns, since usually the world gets over such scandals after some time.
3. Industries with wide dispersion
Number 3 is Industries with wide dispersion.
Buying an ETF of a particular sector or industry means getting the average return of that industry, which can be a good or a bad thing.
If you take all the companies included in an ETF of an industry, you’re going to have a certain dispersion on the returns that each company achieves.
For example you could have an ETF with companies that all did between 5% and 20% gain per year, or an ETF with companies that did between -70% and +300%:
Just to give you an idea.
Now, if the dispersion is really high, meaning there are some wonderful companies and some terrible companies within the ETF, if you are able to identify which companies are good companies and you buy them you have a good chance of having a much better return than the one of the ETF itself.
Let me give you an example to make it clear.
The retail industry is a good industry for stock picking. This is because ETFs in this sector cover a huge amount of companies that tend to have a wide dispersion of returns based on the products they sell.
For example, famous retailers companies that sell electronics can have on average higher growths than retailers of home textiles. If you buy a retail ETF you are forced, in a sense, to buy the electronics shares as well as the home textiles shares, giving you an average return of the whole industry.
But if you know that some companies sell product categories that give better profits and growth you might want to invest in just those instead of in the whole industry.
Or it must not necessarily be a difference in product category. We can say that usually online retailers perform better than physical stores because they don’t always face the same operating costs, although it’s not always like this.
So you might want to invest in some online retailers and avoid physical retailers. Of course I must also say that there are so many ETFs that you can actually buy an “online retailers ETF” like the “ProShares Online Retail ETF”.
4. Personal insights
Situation number 4 is when you have some personal insights about a company that the majority of people doesn’t.
Let’s make something clear: you’re never going to be able to have better insights than the market on a large company. There are financial institutions all over the world that analyze such companies and above all Wall Street and the other institutions always get tips and insights before you do.
But as Peter Lynch says in the book “One up on Wall Street”, small and medium cap companies are not so often analyzed by wall street or big financial institutions. If you can’t beat wall street in their playfield, you may try to play in a different playfield, focusing on smaller companies.
Smaller companies carry bigger risks. The company could face problems and go bankrupt at some point, or it could also never grow and you find yourself stuck with a loser for years.
So generally speaking I think that in most cases investors are better off with ETFs, but if you have some personal insights about a company that the others don’t, this might be a good choice.
For example, you might notice that some of your friends start buying clothes from a new online retailer store, that is still not so famous but your friends tell you how great their products are.
That might be an insight on a company that could have a boom in the next few years.
So maybe you do some financial analysis and you find out that the company has upgraded its stores and hired new product management staff and the new products they rolled out are going extremely well. But so far, the market has not noticed. This type of insight might give you an edge in picking an individual stock over buying a whole retail ETF.
5. You are more patient than Wall Street
Number 5 is patience. Wall Street has a tremendous advantage when it comes to big companies and information about the stock market. But the advantage you have is that you manage your own money.
Let me explain this.
Wall Street can invest better and quicker than you, but they invest with other people’s money. Because of this, they are dependent on the choices of their investors.
So when a Wall Street investment fund starts to underperform the market, investors start pulling their money out because they fear losing more, and Wall Street can’t do anything about it.
So when people pull their money out, the prices start dropping and more and more people get afraid and force wall street to sell. As a result, Wall Street is often unable to do long term investments.
The situation is even worse because everytime the market goes well – hence the stocks are overpriced and shouldn’t be bought – everybody wants to ride the wave and gives money to Wall Street.
And whenever there is a market crash and the prices drop, which is the best moment to buy, Wall Street has no money because all investors pull their money out. This is what they mean when they say that “Wall Street sells on bad news”.
But since you’re investing with your own money, you have the possibility to be much more patient than Wall Street can be. This allows you to invest in single companies that in the long term are going to give you a much higher return than an ETF of that category if:
- You chose the company well
- You won’t freak out when for some news the company stock value drops.
Summary
I personally like to have a healthy balance between individual stocks and ETFs and my portfolio is much more focused on ETFs, but it’s true that you learn more by analyzing companies and picking stocks does give you more control of your portfolio compared to index funds. Nevertheless stock picking is a very dangerous and hard thing to do so you’re almost always better off by investing in index funds.
I’d love to hear what you think about this and if you believe there are other situations in which you consider stock picking is better than ETFs, so let me know in the comment section of the youtube video at the top of this post. If you haven’t, check out my last post about the perfect ETF portfolio for 2023 which is going to be focused on the best ETFs to buy this year.:
Don’t forget to subscribe to my channel, guys, I wish you a great evening, and as always, I’ll see you in the next video. Ciao!
