Investors today commonly choose broad market index funds also known as Exchange Traded Funds (ETF’s) versus individual stocks. Doing so helps ETF investors avoid three risks associated with stocks such as stock risk, sector risk and selection risk.
Here’s why a handful of stocks will be riskier than a broad market ETF consisting of several hundred or even thousands of underlying stocks. First, bad things happen to good companies all the time something investors discover after the stock drops precipitously. Holding hundreds or thousands of stocks through an ETF vastly reduces the risk associated with individual companies.
As well, each year the market return often comes from a few outperforming stocks. Since dropping to low levels in March of 2020 the S&P 500 (a market index of 500 large US companies) has recovered all of its losses. However, 25% of that gain is attributed to the outperformance of just five stocks (Apple, Google, Amazon, Microsoft, and Facebook). If a hand picked US stock portfolio did not hold the same amount of these 5 stocks it would underperform the S&P 500 market return. In 2007, Canadian stock investors dramatically underperformed the Canadian stock market return. In that year Research in Motion, Alcan and Potash accounted for 105% of the S&P TSX Composite return. Remove these 3 stocks and the market index had a negative return in 2007. Canadian stock investors who did not own the same amount of these 3 stocks in their portfolio underperformed. Making matters worse many Canadian investors were overweight bank stocks the worst performing sector in 2007. If a broad market ETF holds the same stocks as the market benchmark then that ETF earns the market return and takes market risk. In doing so the ETF diversifies away single security (stock) risk when bad things happen to good companies.
Sector risk occurs when investors buy too many stocks from one particular industry. The S&P TSX Composite Index consists of about 235 stocks drawn from 10 distinct industry groups. On a quarterly basis, a committee determines which stocks to add to the benchmark portfolio and which will be removed. The objective is for the benchmark to represent the Canadian economy with proper representation from each of the 10 industry sectors. As in the example above investor stock portfolios often become concentrated in bank stocks, or in the case of Alberta, oil and gas stocks, compared to the market portfolio and relative to other Canadian investors. This clearly adds risk with unfortunate consequences. Buying an ETF representing 10 industries with appropriate weightings avoids the risk of over concentrating your portfolio in certain sectors.
Selection risk can also be avoided through index investing. If you are a stock investor… which stocks? How do you choose them? How do you maintain proper diversification and avoid concentration? Your hand picked stock portfolio can have a return that is greater than, equal to or less than the market return. Clearly you don’t want to underperform, and if you want the market return you would buy an ETF. Thus, you must be trying to outperform the market return through careful stock selection. But, isn’t that what everyone is trying to do? Both novice investors and professional advisors are all trying to pick just the best stocks.
Here’s the thing…we’re all using the same publicly available information in an extremely competitive industry. How are you going to choose the best stocks, better then everyone else? What are the chances that you or your advisor could choose worse performing stocks or that you miss out on strong performers? Selection risk is vastly reduced through ETF investing.
Exchange traded funds or index trackers are low fee, diversified and safer alternatives to investing in a handful of stocks. ETF’s offer protection to investors from stock risk, sector risk and selection risk.
Chris Turnbull CFA, CFP, TEP, is an independent Portfolio Manager at the Index House, specializing in passive index portfolio management.