Please ensure Javascript is enabled for purposes of website accessibility

4 Signs You're Ready to Graduate From ETFs to Picking Stocks

By Ryan Downie - Apr 29, 2021 at 9:00AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Tired of indexing with ETFs? Make sure you have these four boxes checked before you start picking stocks for your investment portfolio yourself.

Stock picking is hard. The stats say that most stock pickers, even professional ones, fail to reliably outperform the market. Even if you have a good year or two, it is less likely that you'll replicate that over the long term.

Still, you can't beat the market with market-matching index funds, and there have certainly been successful investors who have developed winning strategies. If you're thinking about taking a more active role in managing your stock portfolio, make sure that you check all of these boxes first.

1. You can handle volatility

Portfolio concentration might be the biggest difference between ETFs and individual stocks. Managing your own portfolio can get hectic and time-consuming when you have to monitor 20 different stocks, let alone 50. Even niche ETFs (like tech-focused ETFs) usually have at least 30 different holdings.

In most cases, a portfolio of individual stocks will be more volatile than a portfolio of ETFs. That's the risk you take to enjoy higher returns. Unexpected bad news for any single stock will have a much more pronounced impact on your overall performance. Even if there isn't any company-specific news, high-beta growth stocks experience higher drawdowns than indexes during bull markets.

All of this is fine if you maintain a long-term view and have your immediate needs covered elsewhere in your financial plan. Growth investments with long time horizons can experience temporary dips along an overall upward trajectory. If you have enough cash in other, less volatile assets, you won't have to worry about short-term stock market swoons, and you won't be forced to sell stocks at inopportune times.

Graduation cap on a pile of $100 bills

Image source: Getty Images

2. You know your strategy

Successful stock picking requires an overall strategy, and your portfolio should be carefully constructed within that framework. Are you trying to maximize growth? Do you want to prioritize income from dividend stocks? Do you want to find value stocks that the market has unwisely left behind? Are you going to use intrinsic valuation methods, or are you just going to look at relative valuation ratios? Do you even care about current valuations at all?

If you can't answer those questions, you should probably sit down and put some more thought into your strategy. You can't know the best stocks to achieve your investment goals unless those goals are clearly stated. Once you have a well-defined approach, make sure you're confident in your ability to analyze stocks and identify the best ones.

3. You understand important metrics

Successful stock picking strategies usually require basic analytical skills, especially for long-term fundamental investors. You should therefore understand the most important metrics for assessing and evaluating different stocks. These ratios and statistics provide essential information related to valuation, profitability, growth, financial health, and operating efficiency. There are dozens that are very common, and they vary among industries.

  • Growth investors should focus on the year-over-year rate of expansion of revenue, operating margin trends, and adjusted earnings. Growth stocks perform well as long as they continue expanding and investors are confident that they will have a path to profitability as they gain scale.
  • Value investors need to focus on valuation metrics such as the PE ratio or enterprise-value-to-EBITDA. It's also important to consider profit margin stability, free cash flow, and return on invested capital to ensure stable and efficient operations. Financial health is also important, so you should recognize red flags exposed by the debt-to-equity ratio, the quick ratio, or interest coverage.
  • Income investors need to think about the above financial health and efficiency ratios, as well as some more specific ones. Dividend yield, dividend growth, the payout ratio, and distribution coverage together indicate the value and stability of an income stock, REIT, or master limited partnership.

Of course, there are other important metrics in addition to the above, so do the homework on the key performance indicators for each stock and industry.

4. You have enough time

Analysis and portfolio composition are time-consuming. It can take days to screen the whole market and build a confident, analytical narrative for each stock in your portfolio. And the job isn't done once you've identified a winner. You may also want to follow the relevant news, especially quarterly earnings. You can also choose to monitor macroeconomic and market-wide news to help you understand which forces are influencing investment returns beyond the performance of any one company.

If your schedule is too full of professional, family, or social obligations to regularly monitor the performance of a handful of stocks, then you might want to keep it simple with indexing and ETFs. If you're ready to dive in with the right amount of time and effort, then you're ready to unlock the upside of active stock picking.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
316%
 
S&P 500 Returns
112%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 07/03/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.