Why you should invest in stock index ETF's and not individual stocks


I don’t invest in individual stocks. Ever. I only invest in index ETFs (UPRO, the 3x S&P 500 ETF) based on my Medium-Long Term Model.¬†Here’s why.
*This is based on the idea of “systematic risk” vs “unsystematic risk”. ETFs allow you to diversify away “unsystematic risk”.

You have to analyze the index anyways

It doesn’t matter if you invest in index ETFs or individual stocks. You have to watch the index anyways and predict its significant corrections or bear markets. Individual stocks are highly correlated to eachother.

  1. A strong rally will lift most stocks higher, even if the individual company’s fundamentals are weak.
  2. A significant correction or bear market in the broad index will push most stocks down, even if the individual company’s fundamentals are strong.

Almost no individual stocks can escape a large downturn in the index unscathed. For example, 2008 brought almost every stock down. The significant correction in 2011 brought almost every stock down too.
The Cumulative Advance/Decline line adds the # of stocks that are going up and subtracts the # of stocks that are going down. Notice how almost every single stock fell in 2008.

So the bottomline is simple. You cannot invest or trade individual stocks without understanding the broad index first.

Individual stocks have a lot of problems that the index doesn’t

Retail investors and traders in individual stocks need to do a lot of extra homework that investors and traders in index ETF’s don’t need to do.
How much do you understand about the industry?
Individual stocks are heavily influenced by their industries/sectors. A sector that’s sinking (e.g. retail right now) will drag most of its related stocks down with it, regardless of the company’s own fundamentals. A lot of hedge funds and investors play sector ETFs nowadays. When they sell a sector ETF, their selling puts pressure on every stock in the ETF. Other investors automatically go for buzzwords. If “retail” is a bad financial buzzword this year, they’ll sell anything that sounds like its related to “retail”.
So how much do you understand about the stock’s respective industry? Just reading a few online reports is not enough. In order to be a successful trader or investor, you need to have an advantage over others. If you’re only reading a few online reports, then you don’t have an advantage. In order to truly understand a sector, you need to attend multiple shareholder conferences and make contacts within the industry. There’s a lot of knowledge that you won’t pick up on until you actually come in contact with the industry.
How much do you understand about the individual company?
How much do you understand about the company’s current products? Upcoming products? Strength of competitors? Defensiveness of its own market share?
Future sales targets tend to be wrong, particularly for tech companies. Actual revenues tend to vary greatly from projected revenues.
Do you really understand how strong the management team is? Do you have access to management? (Unless you’re a large institutional investor, you probably don’t.)
Individual events and pieces of news also impact individual stocks. These company-specific news don’t have much of a consistent impact on the stock market index because no single company dominates the stock market.
Here’s how Facebook crashed on Cambridge Analytica news.

Can you guess the next earnings report?
Individual stocks can be heavily influenced by their earnings reports in the short term. Here’s an Amazon chart.

Can you guess whether the next earnings report will beat or miss expectations? More importantly, can you guess how the market will react to the next earnings report? Sometimes the market will go down on an upbeat earnings report, and sometimes the market will go up on a downbeat earnings report!
This isn’t a problem for the broad index. Individual earnings reports have little impact on the broad stock market index.

Simplicity

Investing and trading the index is simple. All you need to do is understand where the broad market is going. Investing/trading individual stocks is hard, particularly when several factors conflict with each other. Here’s an example. What happens if….

  1. The broad stock market is bullish.
  2. The sector as a whole is experiencing decent growth.
  3. The company’s own fundamentals are weakening, but not terrible.

Do you buy or sell the stock? It’s hard to say. A company’s stock price will sometimes rise even if its own fundamentals are deteriorating.

Leave a Comment