FINANCE

ETFs: The mass market alternative to individual stocks

© Wance Paleri on Unsplash
© Wance Paleri on Unsplash

Martin Fiedler is the founder and owner of  FINANZSACHE, a knowledge portal for financial topics. In this guest post, he deals with the question of how and whether one should invest in individual stocks.

Hardly any other financial product in the world of stock exchange attracts as much attention as this one. We are talking about shares in listed companies. What advantages and disadvantages do investments of this kind offer, but also what pitfalls and misunderstandings there are around stocks, that’s what the following text is about.

What do most people think of when they talk about stocks? Most of the time, these will be big names such as Tesla, Apple, or Alphabet. The second thought is usually “but that’s all far too risky“. The low proportion of shareholders in German-speaking countries, at just around 17%, shows that this attitude in the broad masses should not be so far removed from reality. Incidentally, this is the same value as for the dot-com bubble. The proportion of shareholders in the USA, on the other hand, is around 56%.

When stocks are equated with individual stocks, this type of investment is indeed risky for a retail investor for whom investing is far from a hobby, let alone a genuine interest in it.

People are right: single stocks are too risky!

This assessment does not only apply to moderately interested small investors. Even professional fund managers find it difficult to choose the right stocks.

This is primarily due to the fact that stock markets are considered to be largely efficient. In short: the market has largely priced in all the information available to it. It is undisputed that this does not apply in every case and does not apply to every piece of information. However, the market efficiency hypothesis is useful as a rough model.

So, to be able to make a profit with single stocks, there are two ways:

  • You take a risk and hope that something will happen in the future that will push the current price even higher.
  • You study the company in detail and find direct or indirect factors that the market has not yet priced in.

While the latter can be an exciting quest for some, it would be unrealistic to assume that this is a good tactic for a large part of the population. The high efficiency in the market makes the search for inefficiencies in the market an extremely time-consuming or expensive undertaking.

Furthermore, one must be aware that even the majority of experienced fund managers fail in this endeavor.

And by the way, we are not talking about short periods of time.

In short periods of time, anyone can have success in the stock market. This isn’t art. The trick is to be able to repeat this success systematically in order not to lose your profits again with a single trade. This requires a good strategy.

So if one speaks of “investing in stocks” and means the purchase of individual, selected entrepreneurs, one is actually rightly concerned, at least in most cases, about the loss of one’s capital.

What is the mass market alternative to individual shares?

Some of you may already have guessed: the alternative is equity funds. But: Funds are not just funds. There is an important distinction to be made in the type of administration. There are actively managed funds and passively managed funds.

What is often recommended by advisors in the bank or other professional investment advisors are actively managed funds. The treacherous thing about it: at first glance, everything sounds damn good. In addition, there is something for every taste. From various countries, across different industries to exotic mixtures, everything is there.

The problem? People are more fallible than you like to admit. A brief turn to the day trading area: There is now good data on trading CFD derivatives. The loss rate here is around 75%. Still, most think they will be among the 25% winners.

For investors who are more long-term oriented, the loss rate is less dramatic due to the less speculative character. Nevertheless, it also makes a huge difference here whether we are talking about so-called stock picking, i.e. putting together your own portfolio from individual stocks, or about ETFs, which simply replicate an index.

Indices are the benchmark for an asset class. For example, if an index returns an average of 8% per year, but your personal stock picking strategy only generates 5%, then you are performing below the market average.

While outperforming the market average sounds like an easy task for many beginners, the opposite is true.

This brings us back to ETFs.

ETFs are passive funds that mirror an index and are in many cases well diversified. With active funds, on the other hand, a fund manager takes care of stock selection. In the case of particularly talented fund managers, this works exceptionally well in some cases. The majority, however, fails in trying to beat the market. Passive funds such as ETFs are therefore superior to active funds in most cases.

The point here, by the way, isn’t that single-stock strategies can’t work. Due to the complexity of the financial markets, however, they do not necessarily trade for the general public.

And yes, strictly speaking, even with ETFs, a certain amount of speculation cannot be dismissed out of hand and is associated with risks. The big difference in comparison to individual shares, however, is the often large diversification, which can prevent risks from being weighted too one-sidedly.

Can stocks go up forever? Doesn’t the endless economic growth have to come to an end at some point?

A popular argument against investing in stocks is concern about our limited resources. It is therefore often said that the “perpetual growth” of the economy must come to an end at some point! Quite understandable, especially in times when the climate issue is attracting more and more attention.

And if resources are not inexhaustible, neither is the economy and therefore the economic strength of companies.

What is overlooked: growth is a question of definition and does not necessarily mean wasting resources. If you equate growth with innovation, for example, things look very different. Humanity has been doing nothing but reinventing and improving things. It is also not to be assumed that there will ever be an end point here. The drive to make things more efficient is strong in all of us.

So to answer the question: no, there is a high probability that the economy will never stop growing. With some names, it will, however. It can therefore be assumed that individual players, who currently play a major role, will eventually be pushed out by more innovative companies. It is possible, but by no means certain, that we will still be looking at Amazon and Google in the distant future.

Despite the fact that there is probably no end point for innovation, it does not mean that there cannot also be sharp declines in the economy and thus large price losses in stocks, which can also last for several years. For example, many of the consequences of combating the corona measures are only now becoming apparent. In addition, there are currently delivery bottlenecks and a general trend towards deglobalization.

Shares as an investment: The most important points

  • Investments in stocks are popular because in most cases there is a value behind them that can be quantified.
  • Beating the market systematically and over the long term with individual stocks is possible, but due to the complexity, it is not suitable for the general public.
  • The alternative to individual stocks are ETFs or actively managed funds. Especially in combination with a savings plan and the compound interest effect, these can be an attractive part of wealth accumulation.
  • When evaluating financial products, people are more fallible than you think. This applies to both the inexperienced newcomer to the stock market and the experienced fund manager.
  • “Stock picks” and “hot picks” of certain stocks should be ignored.

Disclaimer: The information in this text does not constitute investment advice, tax advice, a purchase recommendation or a recommendation for an investment strategy. Please contact your trusted advisor for this.

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