why ETFs are better than Stock picking & Mutual Funds
In the past years I invested a lot in stocks and in particular in tech stocks, because of course they were going great and our human psychology makes us do exactly the opposite of what robots like Warren Buffett do. Something is going great, you buy more. Something drops in value, you buy less. And my journey with stock picking went quite well until the end of last year, where basically all the tech stocks decided to die, slowly, a terrible death.
And since of course I’m the kind of person that does not practice what he preaches, I always knew that ETFs are better in the long term but I kept investing most of my money in single stocks. Well, this ends now. I want to tell you all the reasons why ETFs are the best option for you, for me, for almost everybody. If you’d like to get into finance and you’re not a wall street expert, chances are, you are much better off with ETFs.
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But now, let’s cut to the chase. In this video we are going to discuss the advantages of ETFs and we are going to see why, in the end, ETFs are the best option for you. Be sure to stick to the video ‘till the end because we are also going to go through a couple of strategies that will help you reduce even more any risk connected with investing.
What are ETFs
First and foremost, an ETF, or Exchange Traded Fund, is nothing more than a basket of assets or securities, like company stocks, crypto, precious metals, Real Estate and many others. To make it simple, let’s focus on company stocks.
An ETF is a package that contains stocks of several companies and when you buy this ETF you are automatically getting a part of all of these companies instead of having to buy the company stocks individually. So for example if you like the technology sector, instead of having to buy Amazon, Google, Apple, Microsoft and so on you could buy an ETF of the technology sector and by spending much less you get a slice of hundreds of tech companies.
There are ETFs that cover a single industry or sector, like technology, industrial, health, consumer discretionary. Some ETFs focus on only U.S. offerings, while others have a global outlook or focus on emerging economies. There are ETFs of literally everything.
Advantages of ETFs vs Stock Picking
1. ETFs diversify your investment and lower risk
Now, the advantage Nr. 1 is that ETFs lower your risk by diversifying your investment. Since the ETF is diversified, because it contains many companies, even if some company stocks lose value, the price of the ETF follows the average growth of all the companies together. This means that compared to a single stock, that could hugely drop in value because something happened with the company, an ETF basically amortizes the losses of some companies with the gains of others.
With one simple trade of an ETF, you get instant diversification. If you want to maximize returns but you don’t want to take great risks, then ETFs are the way to go.
2. ETFs match index performance
Advantage Nr. 2 is: ETFs match indexes’ performance. You can’t never be 100% sure that your investments will bring you profit, but let’s see how ETFs do compared to the two extremes: individual stocks or actively managed mutual funds. Individual stocks are highly risky, we know that. You buy a stock, and if you didn’t do your due diligence it could go down a lot and you can also lose everything.
On the other side of the table you have actively managed mutual funds: investment funds, made out of many stocks, that are actively managed by a financial expert of a bank, and here the problem lies in the task that this financial expert has: his task is to try to outperform the market. So imagine a human being, which is an average Wall Street guy or banker and not Warren Buffett, who wants to outperform the market. Good luck with that. I can tell you for sure that most of the time they underperform the market.
You may have some years where particular stock picks of these mutual funds perform great, but in the long term they make more mistakes than good decisions. And here come ETFs to the rescue: they don’t try to outperform the market but instead, they simply replicate it. ETFs track indexes. You are never going to have big surprises because a good ETF will always follow the progress of the underlying market index that it invests in.
3. ETFs make accessing markets easy
Advantage Nr. 3 is: ETFs make accessing markets easy. There is usually an ETF for whatever you are looking to invest in, from a country in Asia to a stock sector like pharmaceuticals —and even commodities like gold. So now let’s say you’ve just heard from Elon Musk that the Chinese economy will surpass the United States’ at least two-fold and you want to invest in that.
Well, If you would like to invest in some difficult-to-access markets such as this or even emerging markets, it would be hard to do it by entering particular exchanges and buying all the individual stocks. But now, you can find a lot of ETFs that are based on these markets and they did the work for you, so you just buy the ETF and poof, you are automatically an owner of shares of hundreds of chinese companies.
4. ETFs are transparent so you know what you are getting
Advantage Nr. 4: ETFs are transparent, so you know what you are getting. For every existing ETF you can find detailed information online on all the companies included, their percentages, and the returns of the past.
In the case of actively managed funds, the portfolio manager can choose not to reveal the investments in the fund so you are just giving him the money and trusting him to do the right thing. (risata) – No, but really.
And even if they reveal the investment, being those funds actively managed they often decide to get rid of some stocks and buy different ones, so you can never really know from the beginning what you are going to get with time. Instead, let’s say that you like technology and you want to invest in the Vanguard Information Technology ETF.
You go on the Vanguard Website, search for the Information Technology ETF and here you go: from this page you get all the information you can possibly need about the ETF. Asset class, category, expense ratio… by the way, the expense ratio is extremely important and is the yearly fee that you are charged for possessing the ETF.
I made a video about the best growth ETFs and in the end I showed with actual numbers how much the expense ratio is going to help or destroy your investment in the long term. So check that video out if you want. Anyway, you can also see an overview with the main info about the ETF, the yearly returns, but the interesting part comes next because you have a graph of the performance of the last few years.
Look at that, of course this year there has been a huge drop – which by the way should be an incentive to buy – but look at the average growth of the last 5 and 10 years. These are just incredible numbers. You are not going to get these numbers in the long term by picking stocks.
But anyway, what I wanted to show you is that if you scroll down you can get to the portfolio composition, and this is pretty interesting because you see all fundamentals of this ETF, and going more down you find the sector composition, like application software, communication equipment and so on with the percentage weight, and even more interesting you find the list of the companies that you are going to get if you buy the ETF and their percentage weight on the fund. So ETFs are transparent and you know exactly what you get by buying them.
5. ETFs are easy to trade
Advantage Nr. 5 is: ETFs are as easy to trade as stocks, because they are bought and sold on an exchange like stocks. So it’s not like having to go to the bank, talk to a guy that you don’t even know how good he really is and sign a bunch of documents to have him take your money. With ETFs, you can simply buy and sell your ETF via your broker app at any time when the market is open in a matter of seconds.
6. ETFs are cheaper to hold
Nr. 6: ETFs are cheaper to hold. Again: Actively managed funds have really high management expenses, so you get a fee which is usually a couple of percentage points per year. The annual management fee for ETFs, which is the Expense Ratio I mentioned before, is typically around 0.07% up to 0.4-0.7%, so nothing in comparison. And if you think that paying 2-3% per year for a mutual fund is not so much, think again.
Let’s say that you invest 10.000$ in a Vanguard ETF that brings you a 9% return per year and has an expense Ratio of 0.07%. And then you invest another 10.000$ in a mutual fund that asks for 3% per year. After 30 years, the ETF has grown to a value of around 130.000$, while the mutual fund? Only 53.000$. So think about it: the Fund manager asked you for just 3%, but in the end he took home 77.000$ and you only 53.000$.
So there’s no doubt that the expense ratio plays an extremely important role in the long term and, except for some cases, ETFs offer good expense ratios. And by the way, even a difference between an ETF with 0.07% expense ratio and another with 0.7% is going to be huge in the long term. If you are curious to know more about how to choose ETFs and also want a list of the best growth ETFs to invest in in 2022, check out my video that I’ll link here.
Two ways to reduce the risk
Ok, we discussed many reasons why ETFs are actually your best option. Better than picking stocks and for sure even better than giving your money to a financial expert of a bank. But still some of you might not be convinced and see investing as a risk, even if this risk is drastically reduced if you invest in ETFs. So let me give you 2 pieces of advice that you can use to reduce furthermore the risks associated with investing.
1. Dollar Cost Averaging
The first thing you should do when investing in an ETF is the so-called “Dollar-cost averaging” (DCA). What you do is you invest a defined sum of money periodically, for example every month, and you do this independently from the market development. It doesn’t matter if the market is going down or up, you keep investing the same sum every month.
It might sound inefficient, but in most cases it allows you to achieve the best gains because it prevents your emotions from ruining your investment strategy.
If you let yourself buy and sell stocks or ETFs as you want, there’s a really high probability that you will buy more when you see that stocks are going up, and sell when you see them drop, because unfortunately this is how human nature works.
When you invest the same amount independently of how the market is going, what happens is that mathematically your gains will follow the average growth trend of the ETF, cutting through all spikes and crashes.
1. Diversify more
The second suggestion is diversifying even more. Buying an ETF instead of individual stocks is already a good way to diversify your portfolio, but even better than that is if you diversify by buying more ETFs. If you believe that the asian market will boom at some point, you might think of investing all your money on an ETF about asian companies.
You might be right, but you might be wrong. Spreading your investments across different sectors, geographies and asset classes will smooth the big gains but also the big crashes, allowing you to enjoy, most probably, a long term constant growth of your portfolio without big surprises.
Why ETFs are probably the best option for you
So, let me give you my thoughts now, on why ETFs are the best option for you – and for me.
Warren Buffett says that if you know what you are doing, you don’t need to protect yourself and diversify for no reason. But he also openly says that, for most people, ETFs and index investing are the best choices, because he knows very well that there are not so many “Buffets” around the world. And he’s right.
In the world of finance, actively managed investment funds typically underperform compared to popular indexes like the S&P 500. This is called in jargon “beating the market”, and apparently almost nobody manages to.
According to an analysis of the S&P SPIVA report, 95.4% of all actively managed equity funds underperformed their respective benchmark over the last 20 years.
Not only that. More than 80% of large-cap funds underperformed the S&P 500 over the last five years. So what you have is that the majority of investment professionals, who spend their full-time job trying to beat the market and have decades of experience and access to whatever resource they need, usually can’t beat the market. So why do individual investors like us think they can?
It’s our human psychology, and our predisposition to risk. We see single stocks going up 120% in one year and we feel the hope that we can get one of those beasts before they grow. So it becomes hard for us to settle for an ETF of the S&P500 which will give us an average of 8-10% per year. And still, with the highest probability in the end we will perform long term worse than the S&P500. Maybe one year or two we can be lucky and outperform it, but not in the long term.
This is the reason why I believe that almost everybody would perform better long term if investing in good ETFs that mimic the market benchmarks, instead of picking individual stocks. What you do with your money is ultimately your decision and, depending on your finances you could decide to allocate part of your investme nts to ETFs and parts to individual stocks, and over the long term compare where you got the best returns.
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