As we build the size of our portfolio through gains over time and continued savings and reinvestment we may want to consider an alternative option of equity investing compared to the exchange-traded fund strategy used in the prior section. The main deterrent from buying individual stocks with a smaller portfolio was that we didn’t want to incur the trading costs of spreading our money across many individual stocks. We also didn’t want to only hold a few individual stocks since we would face risks of being undiversified should one of our stock holdings face unforeseen troubles, thus potentially causing us to lose a large part of our total investment.
Though one would be fine holding the portfolio of ETFs for quite some time as our investments build up, there are several potential advantages to buying a diversified portfolio of individual stocks alongside a core portfolio holding of ETFs:
- ETFs are made to cover the entire equity spectrum – including the sectors that may be currently overvalued or that may have limited long-term growth prospects.
- They are also designed to include all companies within a sector, even those that are likely on a long-term decline.
- By design, many ETFs are made to track stock market indexes like the S&P 500 or a broader market measure that includes smaller companies as well. Indexes are usually designed to give the most weight to the highest valued companies, also known as a market capitalization weighting. Therefore, the currently largest and most successful companies in the world and their share performance will have a more significant impact on the index (and thus the ETF’s) price movement. This goes against the timely investor creed of “buy low, sell high” – by buying an index fund you are basically buying a larger stake in companies that are currently at a higher valuation relative to the stock market.
- It is extremely difficult to pick individual stocks that outperform an index over the long-term – but if you buy a fund that tracks an index (before they charge their fees) then you are guaranteed that you will underperform the index after fees.
- By buying companies directly you can lower ongoing fees from the ETF or mutual fund, and be able to manage the account more tax-efficiently by harvesting capital losses and avoiding a sale of your most appreciated stocks.
This is not to say that the exchange-traded fund strategies in the prior section are not good investments – it is more so that once our portfolios grow we may be able to grow into a new strategy. If you are not comfortable with the additional risks of selecting individual stocks on your own then you will be fine growing your portfolio with ETF investments. If you have more experience and a larger portfolio, then selecting individual stocks might be a favorable strategy to keep diversified and lower the ongoing portfolio management costs.
There are several important factors to keep in mind if you choose to select individual stocks while you are building a portfolio:
- A well-diversified stock portfolio will consist of 25-30 individual stocks of large and medium-sized firms spread across the major sectors of the U.S. economy. You want to buy companies across the different sectors of the economy to reflect the current economy so you are not essentially placing a bet on which type of company will succeed going forward. Placing a bet on a sector can cause your performance to vary greatly from the market, which can set you up for a large underperformance.
- No individual stock should hold over a 4-5% allocation in the portfolio in order to prevent a significant overall loss to the portfolio should a company enter into unforeseen troubles and wipe out shareholders (as seen in prior examples of Enron, WorldCom and Lehman Brothers).
- It is wise to continue using mutual funds and exchange-traded funds to maintain diversification to foreign and emerging markets, as well as smaller domestic companies.
As with the previous example – if you had a near-term goal then you would lower your percentage allocations to stocks and increase it to bonds and cash. The actual percentages will depend on the size of your commitment and the distance to it. If you have a $50,000 portfolio and needed $10,000 for a down payment in 5 years then right now you might put $5,000 in a fixed income fund. Over the next few years you would gradually increase that position, and once the payment is only a year or two away you would begin moving that fixed income allocation into the ultra-safe cash position.
Once the down payment (or any other event) is passed, then your portfolio could return to a near 100% stock allocation (with a cash “buffer”) in order to achieve long-term growth. Your situation will be unique, so do your own research and choose your investments carefully! If you do not have experience with analyzing the financial health of a company, then you can either hire a professional to pick individual securities for your portfolio, or you can continue to invest with low-cost mutual funds or exchange-traded funds.