3 Ways to Minimize Your Risk to Individual Stocks
Ron DeLegge, Editor
November 18, 2010
SAN DIEGO (ETFguide.com) – Over the past year and a half global equities haven risen sharply but millions of investors still have a portfolio of stocks doing nothing. Either they've owned underperforming companies or even worse, ones that have been driven to bankruptcy.
How can you minimize your risk to individual stocks? One strategy is to own ETFs that own a broad group of stocks instead of betting your future on just one individual company.
In this regard, ETFs can be successfully substituted in the place of individual stocks from three angles: 1) Market size, 2) Investing style and 3) Industry sector.
Let’s analyze each strategy.
What do Best Buy (NYSE: BBY), McDonald’s (NYSE: MCD) and Starbucks (NasdaqGS: SBUX) all have in common? Not only are they recognized consumer brands but they are all large company stocks. Which ones do you buy?
The stock replacement strategy solves the investor’s dilemma of which stocks to buy. Since stocks come in three general sizes (Large cap, mid cap and small cap) simply owning a corresponding ETF to match your desired market size accomplishes your mission.
Large cap ETFs like the iShares Russell 1000 (NYSEArca: IWB) or the Vanguard Large Cap ETF (NYSEArca: VV) can be substituted in the place of stocks like Best Buy, McDonald’s and Starbucks. For mid and smaller sized stocks, substitutes like the SPDR S&P MidCap 400 ETF (NYSEArca: MDY) and the Vanguard Small Cap ETF (NYSEArca: VB) can help you to execute your stock replacement strategy.
Virtually any publicly traded stock can easily be substituted with an ETF that matches its market size.
Growth and Value
Another defining characteristic of stocks is whether they are growth or value oriented companies. Generally, stocks with no dividends, faster growing earnings and higher P/E ratios are considered growth stocks. Conversely, stocks with higher dividends, steady earnings and lower P/E ratios are generally categorized as value stocks.
What’s better? Growth or value stocks? It’s really a matter of preference, but here too, ETFs can be substituted in the place of individual stocks.
Instead of banking your fortunes on a single growth stock like Amazon.com (NasdaqGS: AMZN), growth ETFs like the iShares Russell 1000 Growth ETF (NYSEArca: IWF) or the Vanguard Large Growth ETF (NYSE: VUG) allow you to bank on a group of growth stocks with similar growth characteristics to Amazon.com.
Let’s suppose you’re bullish on the future prospects of the energy sector. You don’t need to buy Chevron (NYSE: CVX), Exxon Mobil (NYSE: XOM) or some other energy stock to participate. The stock replacement strategy allows you to invest in energy related ETFs that own a group of energy stocks. Furthermore, some of these very energy ETFs may even own CVX or XOM!
Corresponding substitutes for CVX or XOM would be the Sector Energy ETF (NYSEArca: XLE) or the SPDR S&P Oil & Gas ETF (NYSEArca: XOP).
The stock replacement strategy works well for just about any stock and its matching industry sector.
Using the Replacement Strategy
The most obvious benefit of the stock replacement strategy is portfolio diversification. In other words, you reduce your financial risk to individual companies by owning a group of companies via a diversified portfolio. Got it?
Interestingly, this is one of the most overlooked secrets of successful investing. It isn’t so much about picking the right stocks, as it is avoiding disasters. Even stocks that are doing well are susceptible to unexpected blowups that not even the best or most intensive stock research can prepare you for. (See Goldman Sachs (NYSE: GS), BP, PLC (NYSE:BP) and Toyota Motors (NYSE: TM))
How long would it take you to build a diversified portfolio of 500 to 1,000 stocks? Before you could finish, the trading costs would likely bankrupt you. Instead of trying to build an investment portfolio one brick at a time, using ETFs can help you to accomplish your goal.
Besides helping you to minimize financial risk, the stock replacement strategy can help you one last way.
Investment study after investment study continues to prove the vast majority of stock portfolios (both amateur and professionally managed) consistently underperform corresponding index funds or index ETFs. What does that mean?
Simply put, by owning a portfolio built upon index ETFs you can avoid all of that chronic underperformance. You also avoid the higher investment costs associated with those losing strategies.
In summary, the stock replacement strategy can be a win-win for you.