4 reasons ETF is a much better and simpler choice than stocks It beats me why the sensible choice of holding an index doesnt appeal, compared to a poorly collated portfolio
Uma Shashikant
Chairperson, Centre for Investment Education and Learning
The idea that portfolios must be simplified as one ages has caught the readers’ attention. Some of the elderly readers of this column have asked for specific steps in this regard. Some have sent their portfolios for a review. Some want to know if this can be done at all. I would venture to offer a single stroke simplification that works very well—ETFs (exchange-traded funds). If you hold equity, choose ETFs to earn equity returns with least effort and cost.
We have discussed earlier the case for ETFs, but a good idea can do with some reiteration. Let’s begin with what we typically believe when we construct a portfolio, and what we usually end up with. Our investing journeys are peppered with stories of stupendous success with equity shares, either ours or somebody else’s. How a stock or fund grows to become magically huge in value is a story we cannot hear enough about. Most investors think equity investing is about selecting the right stock.
We also have market crashes and booms becoming news headlines. Whenever I hear the words ‘life-time high’, I cringe. Haven’t we heard it enough since the index crossed the 1,000 level? The equity markets will swing, causing steep changes in values on the way up and down. However, investors tend to believe that somehow these turns can be predicted. They would ideally want to buy low and sell high, and no argument can stop that desire.
We call these two attributes selection and timing. Selection refers to what one buys; timing refers to when one buys. Since market swings occur routinely, and liquidity or cash is needed for acting on one’s desire to buy, market action involves both buying and selling. There is a class of people that rapidly selects and times the market, buying and selling at high frequency. These stock traders also attract enough investor attention.
What does all this focus on timing and selection result in? Investors end up with a long list of stocks in which they hold too little. When they buy, they are not sure if they have the right stock at the right time. Hence, they invest a small sum. When it does well, they do not top it up because they don’t want to buy when it has already become expensive. If it does not do well, they should ideally sell it, but investors are loath to booking losses. They expect the stock to recover some day. Therefore, our current problem of what many investors admit as an unwieldy portfolio is a result of these shenanigans to buy the right stocks at the right time, and hold a portfolio of winning, multi-bagger stocks. Why is the ETF a much better and simple choice?
First, money is not made by making individual punts on this name or that. Money is made by bringing together various stocks across diverse sectors in a single portfolio. Except for business owners with ESOPs and promoter stakes, who have too many stocks of the businesses they own and operate, all of us need a diversified portfolio.
We all have a portfolio anyway when we hold more than one stock. We have the choice to hold a mishmash of stocks acquired with inadequate information, or a portfolio made up of the largest, liquid, profitable, actively traded, widely held stocks. It beats me why the sensible choice of holding an index doesn’t appeal, compared to a poorly collated portfolio. An ETF is a readymade portfolio representing the best in that segment and available to buy as a single product.
Second, for a portfolio to perform well, it should undoubtedly have winning stocks. More importantly, it should weed out what is not working. An index, on the basis of which an ETF is constructed, is monitored by a special committee of the stock exchange to drop any business that does not perform well, or does not meet the criteria for selection. It is automatic and immediate. No action is required on the part of the investor when the underlying portfolio is reworked to drop poor quality stocks. Can it get better than this?
Third, a portfolio can have all the good stocks that one has very cleverly bought, but how it grows in value depends on one more factor: quantity. I have heard many stories of investors holding a multibagger stock they can’t brag enough about. I bought it at Rs.10 when no one was buying, and now it is at Rs.1,200, they would say. How much did you invest, I would ask. I bought 50 shares, they would say. How can this multi-bagger make a difference to an investor’s wealth if it is a tiny proportion of the portfolio?
How does the index solve this problem? Let us assume everyone bought an equal number of every stock in the market. People did not want to bother with the question of how many to buy and treated them equally. However, every company is of a different size. Some have issued a large number of shares; some offer less. Pause to consider this: if everyone held the same number of each stock, the stocks of small companies would get depleted, while those of bigger companies would still be available. Hence, the more the capital of a company, the more the number of equal portfolios in which it will figure. This is the principle of marketcap weightage that the index follows. How much is invested in each stock is simply proportional to how much capital it has, multiplied by the market price. The ETF weighs each stock according to this formula.
Fourth, ETFs are cheap and operationally easy. It’s a single product that holds all stocks of an index in proportion to their market caps. It is the cheapest to buy; 25 p at the most as annual cost. It’s easy to buy on a stock trading platform, just like a stock. It’s excellent for buying and holding without having to worry about the everyday investor questions: Am I holding good stocks? Is something going wrong that I should act? Am I holding enough? ETFs pay no commission, so no one will bring it to you or push you to buy a product that is actually good for you.
To simplify your portfolio, you need to tell yourself that human intervention in selecting and timing the market, and building a portfolio is fraught with errors. It is expensive and time-consuming, calling for skills and luck. ETFs make no such pretense and simply track the market. One reader heard this from me and asked, “So what is the best time to buy an ETF?” Some stories are often told, but seldom heard.
(The author is CHAIRPERSON, CENTRE FOR INVESTMENT EDUCATION AND LEARNING.)
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This story originally appeared on: India Times - Author:Faqs of Insurances
