Investing in individual stocks can make you rich. But in stark contrast to many of the promotional materials you'll see just about everywhere on the internet, stock investing isn't always easy. For every hugely successful stock that takes a modest investment and turns it into much, much more, there are dozens of stocks that tread water or end up losing money for their shareholders. Moreover, even the stocks that do well over time nevertheless go through difficult periods that challenge the resolve of their investors. To multiply your initial investment by two, five, 10, or even more, you'll likely have to endure times along the way during which you see much of your hard-earned gains disappear.
Fortunately, there's an alternative to individual stock investing that many investors will find much more comfortable. You might have to give up the potential to see extremely large gains in relatively short periods of time, but for long-term investors, there's still a solid chance that you'll be able to realize life-changing returns given enough time. Throughout the month of March, the Voyager Portfolio will be looking at this method that investors can use to get stock market exposure without individual stock risk.
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How diversification works
One of the basic principles of successful investing is diversification. The idea is that because you can't know for sure that any single stock is going to be a big winner for its shareholders, splitting up your investment capital across many different stocks gives you a better chance of finding it.
Take a simple example. Say there are ten companies that you think each have an equal chance of producing returns of 20 times their initial investment. However, only one will succeed, and the others will be total losses for their investors.
If you decide to put all of your capital into one stock, then 10% of the time, you'll score that 20x return. However, the other 90% of the time, you'll lose everything.
Consider instead what happens if you put one-tenth of your money into each of the 10 stocks. Nine of those positions will be complete losses, but the 10th will produce the 20x return. You won't be as big a winner in this situation because you only put a tenth of your investment capital into that winner. But after accounting for gains and losses, you'll end up with double the money you started with – even though 90% of your stock picks were complete losers.
Enter ETFs
Exchange-traded funds use this principle of diversification to make stock investing easier. Rather than owning a single stock, ETFs hold baskets of dozens, hundreds, or even thousands of different stocks. You can find ETFs that seek to cover the entire stock market, stocks in a particular sector or industry, or stocks that share certain characteristics like paying dividends or having attractive valuations based on conventional financial metrics.
ETFs aren't immune from market downturns, but they do protect against huge losses in an individual stock position. If a stock drops 20% in a day, it might do a lot of damage to your portfolio if you own it individually. But if your ETF has just a 1% position in that stock, then that 20% decline will only hit your ETF's return by two-tenths of a percentage point. That's a lot easier for most investors to stomach.
If ETFs interest you, then the next question you might be asking is how one can best choose from the many different exchange-traded funds out there. Over the course of this month, you'll see 10 different ETFs highlighted for consideration by the Voyager Portfolio. They'll cover a wide range of themes, so at least one might be exactly what you're looking for to help you feel more comfortable about your stock investing and worry less about sharp losses in the future.
