Introduction:
I am a financial thinker and write a blog about financial thinking and ETF investing. Started investing with direct stock investments, but later I found that ETF funds are an excellent tool for cost-effectively diversifying the investment portfolio. Now I go through the benefits, risks, and weaknesses of ETF investing and direct stock investments. In my opinion, a balanced investment portfolio includes direct equity investments and ETFs, or only ETFs.
What is ETF investing?
ETF is an abbreviation for Exchange-Traded Fund, i.e. a fund traded like a stock. You can subscribe to traditional funds with any amount you want, for example, 1,000 euros. ETFs are not subscribed to with any amount, but shares are bought from them on the stock exchange in the same way as company shares are bought piece by piece. Thus, the unit price of ETFs determines the size of the purchase; if the price of one share was, for example, 55 euros, then one thousand euros could buy 18 shares.
In most cases, ETF investing funds follow an index, for example, the American S&P500 index, which is the world’s most followed stock market index. ETFs can also track the price of a commodity, such as gold or oil, so you can easily and efficiently diversify your investments into different asset classes. Most ETFs are passive, index-tracking funds, but there are also actively managed funds. So you should carefully familiarize yourself with what you want and what you are getting. In the case of stock market indices, it is advisable for tax reasons to choose ETFs that reinvest dividends within the fund. In this case, you save on dividend taxes and get to fully enjoy the interest-for-interest effect.
What are the benefits of ETF investing?
ETFs can contain shares of hundreds or even thousands of companies packaged into one product. Therefore, by buying one product, you have the opportunity to get a really wide diversification between different industries and different geographical areas. In this way, you can get such a broad diversification that, in principle, you could get a valid investment portfolio in terms of risk management with just one product. This is easy and cost-effective.
Thanks to good diversification, the ETF gives you an average return on the market. This may sound weak, but according to research, even a few professionals manage to get the market’s average return on their investments in the long term. It is therefore a fairly reasonable return expectation, especially when you take into account the time and effort spent, which in the case of ETF investments remains minimal. The equation is further improved by the low costs of ETFs compared to traditional funds. If the costs of traditional bank-managed funds are around 1%, then in ETFs the normal costs are only a fifth of this, or around 0.2%. Maybe this is the reason why banks don’t advertise ETFs too much.
ETF funds are excellent for long-term investing, where the fund is bought to be held for years or decades. The products are tax-efficient, thanks to the reinvestment of dividends, and in addition, the indexes correct themselves if a company in the index performs poorly. The company drops out of the index and some more successful company takes its place. Therefore, there is no risk of bankruptcy.
For the reasons mentioned above, ETFs are perfectly suited as monthly savings targets, where selected products are bought long-term every month. In this way, you also get temporal diversification in your investment portfolio and avoid the risk of having bought everything just when the prices were at their highest. Monthly savings is also an excellent way to save and invest for wage earners, which most of us are.
What are the risks and weaknesses of ETF investing?
ETFs are not immune to a drop in value if the assets they contain go down. So, as in the case of all other asset classes, ETFs can also drop if the economy slows down. At worst, ETFs can be very complex products that can be very challenging to value. For this reason, it can be difficult to predict how the price of the ETF will move. Careful familiarization with ETF holdings is therefore necessary.
In the case of some smaller ETFs, you may face a liquidity risk, i.e. you may not be able to sell fund shares when you want to. It is therefore worth paying attention to the amount of net assets managed by the ETF. If it is less than one hundred million euros (€100,000,000), the liquidity risk may be a real risk. In this case, selling can become more expensive than anticipated when a tight spot comes, when there are no buyers available at the desired price.
The idea of ETFs is to diversify and minimize risks, so for this reason the risks associated with them are mainly product technical. By choosing big ETFs from big houses (e.g. BlackRock iShares) for your portfolio, you stay on clear waters.
What is direct equity investment?
Direct equity investments are certainly familiar to most people reading this text. So it is the shares of individual companies that can be bought on the stock exchange. For example, a Nokia or Nordea share is like this. As a rule of thumb, one could consider that a single share always represents one company.
What are the benefits of direct equity investments?
Only direct equity investments enable a full view of the success of an individual company. So if you have a strong vision of a company’s future. Then by investing directly in the company’s shares, you can become a part of this story. In this case, you can fully enjoy the profits if the company is successful. At best, this can lead to excess returns that index investors can only dream of.
Many studies have identified that with the shares of around 10 companies from different geographical areas and different industries, you can get enough diversification in your investment portfolio. This is still a reasonably manageable number of stocks, so ETFs are not necessarily needed for a well-diversified portfolio. In addition, with direct shares, you can decide to choose only the best companies in the industry for your portfolio. Market leaders often do best in downturns, so this can be a good strategy in case of downturns.
Direct stock investments work particularly well if you can get close to an industry for your work in a way that gives you an informational advantage compared to other investors. In Finland, such a sector could be, for example, the forest industry. where we have the biggest gamblers on the domestic stock market (UPM, Stora Enso, Metsä Board).
What are the risks and weaknesses of stock investing?
The biggest risk you can take in the investment world is the stock of a single company. Industries are changing and new competitors are constantly emerging. The more time passes, the greater the risk that a competitor will disrupt the industry and put the old players in a difficult position. This can happen even to market leaders. For this reason, shareholders can never rest, but must actively monitor market events. You shouldn’t react to every piece of news, but you should always know where to go and what to expect. For these reasons, it is difficult to recommend direct stock investments for long-term holding, if you are not ready to actively monitor the market.
While it is possible to create comprehensive diversification across industries and geographies with the stocks of individual companies, it is significantly more difficult than doing the same with ETF investing. Gathering industry knowledge from many different industries can also be tedious and time-consuming. When investing abroad, finding current material in a language you understand can be a challenge. Of course, translation tools are already good these days, so gathering information is by no means impossible.
It is difficult to see direct stock investments as a good monthly savings target, at least in the traditional sense. Where you would buy shares from month to month. It is good to stick to diversification because of risk management. and if you were to buy all the shares in the portfolio every month, the costs could become high, depending on the broker. If you want to buy direct shares to save monthly. Then you should choose a stockbroker with whom you can make small transactions at moderate pricing.
What is a balanced investment portfolio like?
According to my view and experience, a balanced investment portfolio includes ETFs as the cornerstone of the portfolio. In my investment plan, I have defined 50% of the portfolio as a suitable share of ETFs. I invest the remaining 50% in Finnish stocks. To Finns, because up-to-date information about them is easily and comprehensively available. I try to keep investing as technically simple as possible. So that I can focus on what is essential, i.e. analyzing markets and companies. If I wanted to spend less time investing, I would replace direct stock investments with ETFs and other traditional low-cost funds. So you could think that, depending on your own interest and time management. The appropriate weight of ETFs in the portfolio is 50% – 100%.
Stock picking is a nice and rewarding hobby, but especially as wealth grows, the role of risk management is emphasized and diversification matters more and more. In this case, ETFs balance the portfolio excellently through the monthly savings program. For an individual share, I do not recommend more than 10% weight in the portfolio due to risk management, but with a single ETF. The weight may well be more than 10% because these are spread over hundreds of different companies.
