Investing in the stock market is all about choices. Modern equity investing often comes down to a pair of options: buying individual stocks (companies like Apple or Tesla) vs. buying ETFs (exchange-traded funds that track an entire index or sector). On the question of which generally performs better in the market — individual stocks or ETFs — the answer comes down to risk management.
The average ETF is more likely to outperform the average individual stock. This is because an ETF is less likely to provide negative performance over a year or more. Individual stock investing is more likely to net a negative price performance than an index or sector’s ETF during the same period.
ETF outperformance is due to asset diversification and “single stock risk” and their paramount importance for investing. Both deal with risk management, perhaps the most significant factor in all stock market investing strategies. Read on to learn more about the differences between individual stock and ETF investing and what may lead to one outperforming the other.
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Table of Contents
Why Are ETFs More Likely To Outperform Individual Stocks?
In investing, diversification is key for long-term strategies. Diversification is a risk management strategy where a portfolio contains many different kinds and sources of investment.
Part of the reason ETFs have become so popular is that they automatically and quickly provide a retail investor with a diversified portfolio. Whether you invest with SPY (the S&P 500 ETF), QQQ (the NASDAQ, or hi-tech ETF), or any of the many Vanguard industry sector ETFs, you buy a large, diversified portion of the market with one asset.
A diversified portfolio is less volatile and thus less likely to lose significant value over time. A pair of stock’s gains often offset one stock’s loss, and so forth. And each individual stock within an index or industry profile only represents a small fraction of the overall performance of an ETF.
Alternatively, if you purchase an investment in a single individual stock — such as Apple or Tesla — your entire performance is netted through that single company’s price performance over time.
Buying one stock means less diversification, exposing you more to volatility. There’s a higher reward and risk opportunity for your investment in Apple and Tesla going forward, i.e., a higher gain or loss potential.
The above factors are why, over 5 years, less than 1% of ETFs lost money, whereas up to 34% of individual stocks lost money.
Due to idiosyncratic risk, or “single stock risk,” individual stock investing is thus much riskier than ETF investing.
So what does this mean?
What Is Single Stock Risk?
You’ve probably heard the phrase “don’t put all your eggs in one basket.” The idiom near-perfectly captures the idea of idiosyncratic risk, or “single stock risk,” when it comes to stock market investing.
Single stock risk is the risk related to specific factors and events that affect the performance of a single company. This concept means that by investing in an individual stock, you’re bearing undue risk from the singular events.
These singular events are both recurring (ex: recent sales performance) and one-off (ex: adverse legal ruling), affecting that company alone.
For example, while a poor quarter or a bad legal ruling may tank an individual company’s yearly stock price performance, it’ll only be a small, individualized impact within the overall market or index value of which that stock is a part.
“Single stock risk” means that a single market event could harm your one-stock portfolio’s performance to a large degree. Whereas for a diversified portfolio, such as an investment in the S&P 500 ETF, many market events (or one big global event!) would be required to seriously harm your portfolio’s performance in any given period.
This means that:
- The average ETF is likely to outperform the average individual stock.
- If you do decide to put all your eggs in one basket, you better do your research into that basket!
Speculating vs. Investing
Many modern investors choose to invest in ETFs (or their older cousin, mutual funds) because it’s more efficient or easier. And ETF investing is “easier” in a subjective sense because to make educated, reasonable decisions, you don’t have to do nearly as much research.
You don’t have to pay to hire someone to do that research for you. ETFs don’t require “active management.” You can just buy and hold your diversified asset and go about your day.
But what about someone (maybe you?) looking to beat the market?
By definition, broad, diversified ETFs, such as index funds, can’t ‘beat’ the market because they are the market. In fact, many individual stocks do indeed outperform the market, and most ETFs, in any given year, such as Tesla and Apple in 2020.
But how do you pick which ones? This is the golden question that every investor has been asking since time immemorial. (Fun fact: in finance, the degree of an individual stock’s outperformance of the market or its index is known as “alpha” — and it’s the ultimate goal for every active investor!)
Indeed, you could outperform by buying Tesla instead of the whole QQQ ETF in a given period. But why you made that decision matters.
Was it luck? Did you perform due diligence into Tesla’s current operations and company outlook, read their annual report, and watch all their presentations? Do you just “like” Tesla and want one of their cars? Or do you just enjoy researching and investing in individual stocks?
Rational or not, these are all valid reasons to invest in Tesla and own its stock. But if it’s outperformance over the market you’re looking for with your investment, especially in the long-term, then risk management must enter the picture of your strategy.
Why Tesla May or May Not Beat the Market Again?
Do you know why Tesla beat the market and why they may or may not do it again next period?
Professional investors couldn’t answer such a question. Elon Musk couldn’t answer it, either! In fact, the best investors in the world are hard-pressed to beat the market on a long-term basis.
For example, see Warren Buffett’s famous bet, tracked over 10 years, that his simple S&P 500 index fund investment could beat hedge fund managers’ (i.e., the smartest, most sophisticated investors in the world) active investment strategies. In this challenge, Buffett won — by a lot.
So the S&P 500 beat the hedge fund over a decade? So what?
To summarize these results: if the best, most educated, and intelligent investors in the world can’t beat the market in the long term — then why should anyone think they can?
There’s no guarantee Tesla’s — or any individual stock’s — outperformance of the overall market will continue after a given year.
The SEC requires every fund and every investment advisor to tell investors the same message: “past performance does not predict future results.” This is for a good reason. The stock market is a risky beast, and there’s no real way to predict it.
iShares distinguishes speculating from investing. An investor can make money speculating on hot, individual stocks that are on a good run.
They can outperform the market for a time but can lose a lot of money, too. And more money than you would ever really lose if you invested in the market overall in a diversified ETF.
Risk management through diversification is why, though short-term gains may exceed them for a time, ETFs will likely outperform such speculation (i.e., gambling) on individual stocks from a long-term outlook.
This educational discussion isn’t to equate investing in only Tesla stock with pure speculation or gambling. But you’re undoubtedly taking on much more risk without a diversified portfolio of assets making up your investment.
How Diversification Can Benefit Your Portfolio?
No matter how much due diligence you have done into individual stock, no matter how “safe” a bet that company may be — you’re ultimately making a risky bet just by the function of its singularity.
Investing in even 5 or 10 more stocks can vastly decrease the volatility of a portfolio. In fact, for a portfolio to be nearly maximally diversified, experts recommend you only invest in a basket of about 20 individual stocks.
For such a basket of individual stocks, the question of outperformance versus the average ETF becomes a closer and more comparable battle.
Why? Because investing in 20+ individual stocks nearly annihilates idiosyncratic, or single stock, risk! From here, your individual stock choices and why you make them become about preference because you have equalized your portfolio’s volatility level versus ETF investing through risk management.
Do you want to perform the research and gain knowledge on an investment portfolio of favored individual stocks because you enjoy that process? Or do you prefer efficiency and will just buy a broad market ETF and go about your life?
These questions are what your style of investing comes down to. Endlessly chasing outperformance from either ETFs or individual stocks is akin to chasing after the philosopher’s stone. It is usually a fool’s errand.
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Conclusion
Choosing between ETF and individual stock investing comes down to risk management and preference. Ultimately, ETFs are more likely to outperform individual stocks over a long period.
However, such outperformance isn’t guaranteed. The time one desires to put into the art of investing and the joy one finds in stock market research contribute to strategic choices.
As long as you manage your risk and do your research, long or short, you’ll be fine. Over the long term, a highly diversified portfolio of either ETF(s) or a basket of well-researched individual stocks is likely to increase in value over time.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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