Many investors hire "professionals" to manage their funds for them. In most cases, these professionals simply place their client's money into one of their handful of generic portfolios based on the client's profile. They will ask the client a few questions to get a feel for their risk and return expectations, and then charge them 1% to 3% of their total portfolio per year to invest their money into these generic portfolios. What is the problem with this? With minimal time and effort, most people can achieve superior risk-adjusted returns by investing their money into ETFs or Mutual Funds themselves than by paying someone to manage their money for them.
You Can Do This on Your Own
Money management techniques may seem overwhelming. Many people use this justification to convince themselves that hiring someone else to manage their money is worth the time saved. They think of investing similar to how they view plumbing, for example. You'd hire a plumber to fix your pipes because it not your area of expertise. So shouldn't you also hire an investment professional to manage your money? It is my opinion, that it is far easier and less time consuming to outperform the professionals after fees by investing in index funds than it would be to learn how to do your own plumbing. I am going to work towards debunking this commonly held perception that you need to be financially savvy enough or that you need to have a certain amount of knowledge to create your own portfolio.
Research shows that the vast majority of active investment funds (managed by the professionals in question) have consistently underperformed the passive indexes over the last ten years. That means, by simply taking 5 minutes to invest your money in an S&P 500 ETF (like IVV for example), you would end up with more money than had you'd relied on the vast majority of the active investment professionals who benchmark themselves against the S&P 500 index. The actively managed approach places a heavy reliance on the skills and expertise of the fund managers and their teams, whereas the index-based approach is a simple buy-and-hold ETFs and mutual funds strategy. If we are to look at the historical data, your fund manager likely is not as consistent as their sales pitch would suggest.
Depending on the study, index-funds have historically beat actively managed portfolios between 56% and 83% of the time. Studies have consistently shown that actively managed funds, on average, underperform their benchmarked market indices after fees. As a result, we have seen a massive shift away from active funds and into passive funds.
The Benefits of Doing It On Your Own
A passive investment strategy is easy to follow. While investing your money may seem intimidating and overwhelming, if you invest in index- funds it can be quite easy and approachable. An index fund will simply achieve the returns of the market index it is tracking. An investment in an index-fund displays a belief in the market itself, not necessarily a belief in any individual company. Many investors that have limited knowledge are fine using simple tools for their investment decisions.
In 2012, a British paper known as the observer conducted a contest between three parties to select stocks within the FTSE all-share index. The teams were a group of professional money managers, a group of school children, and a cat. The professional managers used their decade's old investment strategies and their traditional stock-picking methods, and the cat selected its stocks by throwing its favorite toy on a grid of numbers that were allocated to different companies. The cat won the contest. While this is nothing more than anecdotal evidence, it is a good example of how sheer random guesses can often outperform high fee-charging professional money managers.
Warren Buffet entered into a 10-year bet with Protégé Partners that they could not beat the market returns of the S&P 500 index. Protégé Partners are professional money managers, who actively managed their funds with the goal of outperforming the index. Over the course of the experiment, Buffet's investment in the S&P 500 index rose 85.4%. Protégé Partners only managed to increase their portfolio value by 22%. Meaning Buffet achieved nearly four times the returns by doing virtually nothing.
It is surprisingly easy to create your own portfolio by investing in index funds. And historically, doing just that would have outperformed the vast majority of "professionals" looking to charge you 1% to 3% per year to manage your money. If you'd like help in creating your own ETF portfolio, feel free to check out our free ETF Portfolio Builder.
Note: The information provided must not be taken as investment advice. Not all information is correct. The information is presented “as is” for informational purposes only.
Quite naturally, you are putting in money in an investment in the hopes for high returns (which can be compelling with individual stocks. However, individual stocks also expose an investor to high levels of company-specific risk. All risks taken should be compensated with higher returns, otherwise, they are neither optimal nor rational. The Modern Portfolio Theory (which is generally well respected in the field of Finance) hypothesizes that a portfolio with a minimal number of different company’s stocks exposes the investor to high amounts of company-specific risk of which they are not compensated for with higher returns. A better approach is investing in diversified securities like Mutual Fund or ETFs (more on this later).
Individual stock investments can work for some people, and this article is going to tackle both the pros and cons of individual stock investments. But first, we need to talk about the differences between investing in individual stocks and investing in diversified securities like ETFs.
What’s the Difference?
Individual stock investments are simply buying a share, or multiple shares, of a single company’s stock (for example buying 5 shares of Apple stock). These investments are tied to the company’s growth, earnings, and perceived value.
Mutual Funds or index funds involve investing in a pool of multiple companies at the same time. You can pool your investment with other investors and buy hundreds or thousands of stocks in a wide range of companies and sectors. This investment style is different in the sense that individual stock investments focus on a single company and a single stock. Mutual Funds or index funds like ETFs offer a very cheap way for the average person to achieve a well-diversified portfolio.
Why Should You Not Invest in Individual Stocks?
There are multiple reasons why I discourage investing in individual stocks. One of the primary reasons is that the stock market is volatile. Prices can rise and fall very quickly. If a company that you’ve invested in has bad news or a bad earnings report, the price will likely fall substantially before you can react.
The market moves very quickly, and most large financial institutions already have systems installed that make buy-sell transactions almost instantaneously. The average person has a minimal chance of beating them to the sale, and the company’s share price will fall almost instantaneously.
On the contrary, if you are instead invested in an index fund that contains 500 different stocks, bad news from a single stock will hardly affect your portfolio because your exposure to any individual stock is negligible.
There Is Significant Uncertainty for Any Individual Company
The average person generally does not know what the future holds and what internal or external factors will cause a company’s stock price to fluctuate substantially. Our hunches can often feel infallible with regards to a company’s future success. But consider that 90% of traders have historically failed at outperforming the benchmark index, and they at one point considered their hunches to be infallible as well.
Diversifying your investment minimizes the risks you face in the sense that other stocks can now cover up for a bad investment, and this helps in significantly minimizing your losses. With a diversified stock investment portfolio, you will generally see your investments rise and fall with the overall stock market.
Individual investors with diversified portfolios will be minimally affected by major losses of any single company. However, diversifying your stock portfolio by buying huge volumes of individual stocks of different companies is too costly for the average person. Therefore, many investors turn towards index funds (like ETFs) which allows them to pool their money together and purchase a huge basket of different stocks at a low price.