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

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

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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.

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