The investment landscape can appear overwhelming, sometimes, with so many investment choices. One of the more difficult decisions for the modern investor is the one between investing in a fund or investing in individual stocks. Both approaches have advantages and disadvantages.
Advantages and Disadvantages to Buying Stocks
There are definite advantages to purchasing individual stocks instead of a mutual fund or ETF. The most significant benefit is perhaps the degree of control and flexibility an investor has available. Buying individual shares gives an enormous array of choice concerning sector exposure, dividends paid, growth prospects, and ethical investing, to name a few. Another advantage of owning individual stocks is the absence of fund management fees since you are in full control of your investments.
Some of the disadvantages of owning individual stocks include the relatively large number of names an investor needs to have in a portfolio for it to be diversified. Experts say investors need to have 25-30 stocks in a portfolio to diversify away from the firm-specific risk. Buying individual shares can push up trading costs, especially when it comes time to rebalance the portfolio. Instead of making one buying or selling trade, a portfolio of individual stocks may need several trades something experts call “turnover.” Another disadvantage is the more substantial amount of capital required to run a portfolio of individual stocks. Experts believe individual stock investing becomes more cost-effective with portfolios of over $100,000.
Advantages and Disadvantages to Buying ETFs
Most medium to small investors use Exchange Traded Funds (ETFs) to build portfolios. Many automated investing algorithms (robo-advisors) also use ETFs for their asset allocation decisions. ETFs offer a low-cost way for investors to construct a diversified portfolio. Some ETFs have fees as low as 0.04% and depending on the broker some are free. The most significant advantage to ETFs is that they trade like a stock and are very liquid but are multi-asset funds that hold several securities, allowing investors to build diversified portfolios at low cost.
Some of the disadvantages of ETFs include performance and sustainability. Investors need to be careful that they fully understand the ETFs composition and market exposure. Other ETFs trade with leverage and can have up to 3-4x the price reaction to the underlying market. Still, other ETFs are relatively small, with few assets under management. Smaller ETFs are at risk of being liquidated if the asset manager no longer wants to manage and market the fund.
Bottom Line
It depends on your preference however, ETFs have low-cost, diversification benefits that are hard to achieve with individual stocks. Experts say investors need to have 25-30 stocks in a portfolio to diversify away from the firm-specific risk. Trading stocks can be costly for smaller investors who may be able to get the same diversification from a low-cost ETF. On the other hand, ETFs may not be right for investors with more extensive portfolios who have specific investment goals or want to pursue a market view. Buying individual stocks gives an investor greater control and an ability to tailor a portfolio to achieve particular investment goals, return objectives, or dividend yield.
Disclaimer: The writer is an experienced financial consultant who writes for Finscreener.org. The observations he makes are his own and are not intended as investment or trading advice.
