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LESSON SUMMARY
In this third episode, we’ll be laying out some pros and cons that can help you determine whether you should choose to invest in individual stocks or index funds (ETFs). To uncover the question, we’re looking at the historical evidence of the stock market and the best stock picker in the world, Warren Buffett.
LESSON TRANSCRIPT
Welcome to the third lesson of the asset allocation course. We’re going to discuss should we pick individual stocks or should we invest in ETFs. Whenever I refer to ETFs here, it is simply an index ETF — something like the S&P 500, where you buy the market index in stocks. Let’s look at some of the pros and cons.
If you’d pick individual stocks, you have the advantage of having full control. If you do pay individual stocks, you will also quickly see that investing tend to have a positive spillover effect into your professional life especially if you own your own business or if you have the authority to make a lot of decisions in your day job.
When you look into stocks, you’re basically looking into a real business. You’re forced to think like an owner or said in another way, you a better businessman when you invest, and you invest better if you’re a businessman or a woman. Perhaps the best thing is the potential upside. If we look at the stock market in general, we talk about returns in the 6 to 7% range after inflation.
But for you as an investor picking individual stocks, the best will get a much higher return. That will also give you the ability to achieve your financial results much sooner. So, let’s talk about the indexing approach or the ETF approach if you like. As unattractive as 6 to 7% might sound, and with no guarantee that you’ll see that in the future.
The downside is also low with the indexing approach. Perhaps the emotional cost of losing sleep and be stressed about following individual stocks is one of the biggest benefits of being in index investing. You just know that you’re buying a well-diversified portfolio of some of the best stocks out there and then you can just sit back and relax.
So, let’s continue to talk more about index investing. One of the most public indexes in the world is the S&P 500. That is 500 of the biggest publicly traded companies in the U.S. Basically when you buy the index, you buy a tiny piece of all the stocks in the index. Now keep in mind that these are not the 500 best companies in the U.S. Just because they’re the biggest and most traded does not imply that they all top of the class. You also buy companies that are all loaded with debt. You also buy companies that are not even profitable and perhaps we’re not even profitable when they entered into the index.
But again, this is really a question of pros and cons. It’s not time-consuming, and perhaps you will also experience little stress. Now, even though you see these huge drawdowns in the stock market, say a third percent. If you invest in the stock market, there’s just something that is comforting for you if all your other friends and everyone else is also losing 30% of the portfolio too.
Now, it might seem like an odd argument to bring to the table because after all, why should you care too much about what other people think. But if you ever experience your portfolio lose a lot of money, and all you hear is that everyone is making a killing in the stock market. For most people, it’s just harder for you to stick to a strategy. Indexing is truly a great strategy for the vast majority of investors and even for value investors.
Benjamin Graham, the father of value investing, talks about a strategy he called dollar-cost averaging. That is as simple as it is efficient. We talked about how difficult investing is, and especially if you do not perform well compared to your peers, it can be hard. You spend a lot of time. That’s another issue. So, why don’t we just make this as simple as possible? If you buy a low-cost index and continue to add to that position throughout your life, you’ll likely be doing a lot better than most people. You won’t get a Warren Buffett kind of performance. But you still do very well. If you had done so with the U.S. stock market, you have made little more than 6% adjusted for inflation or the past five decades, and that would have given you 20-fold on your investment.
Personally, I love investing. I love finding new stocks and discussing stock picks with my friends but finding and analyzing stocks is also my job. Not everyone likes estimating the intrinsic value for stocks or other asset classes, and perhaps they’re just not interested at all. If you’re not interested in the process, if investing for you is a way to save up to retirement and you couldn’t care less about it, indexing is likely the right thing for you. Even if you are into stocks, there’s just so much stress attached to it. You’ve probably realized already how much I mentioned the concept of stress. It is really important for you as an investor.
One of the reasons why we invest is because we would like to have a good life and a good life is not good if there’s too much stress. For most people, you just end up doubting yourself if things go bad and you might sell a winner too fast and hold on a doubling down on a horrible investment because you feel you want to win your money back. Using a simple and transparent approach like the dollar-cost averaging, I think you will find that it’s a better way of living and more efficient than reading ten books about how to control your emotions. Imagine, if you bought the index, why would you check on the price all the time?
If you want to just keep adding the same amount every month for the next three or four decades, you couldn’t care less about the market dropping a percent or two that day, and you wouldn’t go out celebrating if the market just went up. At the end of the day, the right strategy really depends on you. More than anything, it’s important to remember that you incur risk when you don’t know what you’re doing.
It’s not risky to invest in individual stocks, and it’s not risky to invest in an index either. You just have to know what you’re investing in. Let me give you an example of this. Few people will disagree that Warren Buffett and Elon Musk are both brilliant minds. However, I don’t think Elon Musk would be good at value investing just as I don’t trust Buffett’s skills in reinventing electric cars. It depends on your personality really, and it depends on your skillset. Please keep in mind that if you’re at the end of the day is thinking. This is way too much.
If you go through all the lessons here in the asset allocation course series, and you’re just saying this is way too complicated, you can still pick individual stocks. You can still learn how to do the process. The most important thing is really to ask yourself, “Do I find interesting and fascinating?” Because if you don’t, you won’t be successful. But if your strategy rather is to invest the same amount or a similar amount every month not thinking about the stock market not reading financial reports, then buying an ETF that’s tracking an index and a very, very low cost. That is the way to go.
