Investing in exchange-traded funds (ETFs) can be a wonderful way to make money in the market over time. By investing in low-cost, low-churn index-based ETFs, you can get returns about in line with the market or sector you're tracking, with very little effort.
Still, there comes a time when you may want to take the next step in investing -- moving from buying ETFs to individual company stocks. The dynamics change, though, as individual stocks expose you to more company-specific risks and opportunities. So as you're considering making the move, look for these four signs that you're ready to graduate from ETFs to picking stocks.
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No. 1: You're comfortable with much greater volatility
It is fairly rare for a broad stock market index to rise or fall more than a couple of percentage points in a given day. An individual company's shares, however, can easily leap or fall by 10% or more in a very short amount of time. This is because business-specific news happens.
A company's stock price reflects investors' expectations for the future of that specific enterprise. If something happens that drastically changes what investors think will come to pass, they'll quickly bid up or sell off those shares to reflect the new reality.
As a shareholder in individual company stocks, you need to be comfortable with that type of volatility -- because at some point, it will happen to the shares you own. While you can't avoid it, how you handle it will play a large role in determining how your overall portfolio fares in the long run.
No. 2: You recognize and embrace the power of diversification
A key benefit of ETF-based investing is that you get some level of diversification built into your portfolio with one simple transaction. If you're buying a broad market index ETF, then you'll have some level of market-level diversification. If you're buying a sector ETF, then you'll at least have some exposure to multiple companies in that sector.
Once you start buying individual stocks, you have to build your own diversification into your portfolio in order to benefit from it. The big advantage of diversification is that if one of your investments fails due to company-specific factors, it only affects that portion of your portfolio.
Say, for instance, that you have roughly equal positions in 20 individual stocks that operate in different areas of the economy. If one of those companies should happen to fail, you'd lose roughly 5% of the value of your investments. While you'd feel that blow, the successes of your other investments could easily overcome that challenge and enable you to rebuild your net worth over time.
Contrast that outcome to the non-diversified case where you only own one stock and that stock happens to belong to a failing business. That can leave you in a much more difficult situation to recover from. Indeed, you may not be able to do so in a reasonable amount of time.
No. 3: You recognize your patience edge over Wall Street
Wall Street has tremendous advantages when it comes to the ability to quickly process and react to publicly available information. As a small, individual investor, you'll likely never beat Wall Street on the speed to which you react to news. Instead, the primary advantage you have comes from the fact that you're managing your own money.
Because you're dealing with your own money, you can be much more patient than Wall Street can be. When a Wall Street investment fund starts to underperform the market, investors will often pull money out of that fund, which can potentially cause something of a death spiral for it. As a result, Wall Street has been largely conditioned to be very impatient and unwilling to wait for a longer-term business thesis to play out.
As an individual investor with your own money on the line, you can afford to be more patient to let a longer-term thesis play out. When Wall Street sells on bad news, the selling pressure often drives a stock to below where it would otherwise rationally wind up based on the long-term financial effect of the news itself. That often gives you the chance to buy low -- and patiently wait for the longer-term story to play out and the stock to recover.
No. 4: You think you'd enjoy the challenge and research involved
To invest in individual companies successfully, you need to put in a lot more effort than you do to just pick sector or broad-market exchange-traded funds. For one thing, valuation becomes much more important, since your fortunes are tied to individual businesses instead of sectors or the overall economy. As a result, mastering tools like the discounted cash flow model will help you get a clearer picture of what you're buying for the money you're investing.
In addition, you'll want to keep an eye on the investments you own as they evolve over time. Between their quarterly earnings calls, mid-cycle announcements, and any major breakthroughs that affect them or their operations, investing can quickly become something of a part-time job. You'll want to follow at least the major news from the investments you own. Doing so will help you inform yourself as to whether any news is a signal to buy more, pare back your position, or simply hold on to what you have.
If you're ready, get started now
Picking individual stocks is work, but if done well, it's one of the few part-time jobs that can help you become a millionaire over time. As a result, it's one where if you have the passion, patience, and skills to put in the effort, it's certainly a job worth pursuing. Best of all, between commission-free investing and fractional share purchasing now fairly widely available, it's a role you can get started with even if you haven't yet built a huge nest egg.
If you've taken a look at these four signs and decided that you're ready, then there's no time like the present to get started. The beauty of the modern market is that with such low costs involved in investing, you can make the move with as much -- or as little -- of your portfolio as you'd like. Over time, you can adjust, with a goal of ultimately finding yourself with a mix of stocks, ETFs, and other investments that works well for you.
