SEE: Building An All-ETF Portfolio
Making this choice is no different from any other investment decision. As always, you want to look for ways to reduce your risk. Of course, you want to generate a return that beats the market (create alpha.) Reducing the volatility of an investment is the general method of mitigating risk. Most rational investors give up some upside potential to prevent a potentially catastrophic loss. An investment that offers diversification across an industry group should reduce the portfolio volatility an investor is exposed to. This is one way that diversification through ETFs works in your favor.
When Stock Picking Might Work
Industries or situations where there is a wide dispersion of returns, or instances in which ratios and other forms of fundamental analysis could be used to spot mispricing, offer stock-pickers an opportunity to exceed.
Maybe you have a good legal insight on how well a company is performing, based on your research and experience. This insight gives you an advantage that you can use to lower your risk and achieve a better return. Good research can create value added investment opportunities, rewarding the stock investor.
The retail industry is one group in which stock picking might offer better opportunities than buying an ETF that covers the sector. Companies in the sector tend to have a wide dispersion of returns based on the particular products that they carry, creating an opportunity for the astute stock picker to do well.
SEE: Analyzing Retail Stocks
For example, recently you have noticed that your daughter and her friends prefer a particular retailer. Upon further investigation, you find that the company has upgraded its stores and hired new product management people. This led to the very recent roll out of new products that have caught the eye of your daughter’s age group. So far, the market has not noticed. This type of perspective (and your research) might give you an edge in picking the stock over buying a retail ETF.
Company 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 particular sector, where there is much return dispersion, single stock investments can provide a higher return than a diversified approach.
Often, the stocks in a particular sector are subject to disperse returns, yet investors are unable to select those securities which are likely to continue over-performing. Therefore, they cannot find a way to lower risk and enhance their potential returns by picking one or more stocks in the sector.
SEE: How To Pick The Best ETF
If the drivers of the performance of the company are more difficult to understand, you might consider the ETF. These companies may possess more difficult to evaluate technology or processes that cause them to underperform or do well. Perhaps their performance depends on the successful development and sale of a new unproven technology. The dispersion of returns is wide, and the odds of finding a winner can be quite low. The biotechnology industry is a good example, as many of these companies depend on the successful 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 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.
When deciding 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 returns from the mean. And you can gain an advantage using your knowledge of the industry or the stock.
ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, and regardless of return dispersions, an ETF is your best choice
SEE: 5 ETFs Flaws You Shouldn’t Overlook
The Bottom Line
Whether picking stocks or an ETF, you need to stay up to date on the sector or the stock in order to understand the underlying investment fundamentals. You do not want to see all of your good work go down the drain as time passes.
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