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I have enormous respect for the late John Bogle, the father of passive investing. Financial literature shows that the vast majority of actively managed funds underperform indexes, such as the S&P 500. Furthermore, performance is often determined by asset allocation and buoyed by avoiding excessive expense ratios — a benefit low-cost ETFs deliver.
Mr. Bogle was wary of ETFs, viewing their ease of trading as inducement for irresponsible financial decisions. In fact, he compared an ETF to handing an arsonist a match. However, his viewpoint softened over time, and he eventually acknowledged that a passively managed ETF was a useful tool as long as the investor held it for the long term.
The firm he founded, The Vanguard Group, is now one of the largest issuers of ETFs in the world. Vanguard also published research (“Advisor’s Alpha”) that found an advisor can help investors’ portfolios profit by an extra 3% per year. Advisors accomplish this through appropriate allocation, tax efficiencies, and helping investors avoid emotional decisions. Advisors pursuing a disciplined buy-and-hold strategy can responsibly implement ETFs in client portfolios.
The data supports ETFs being a cornerstone of any securities-based investment strategy, if not the only strategy. I would argue, however, that the market performance you get also includes some cringeworthy times. Is there data on a strategy that matches the performance of the market while also having some downside protection? Well, I wouldn’t be writing this article if there wasn’t.
Oracle of Omaha Is Not Omniscient
First, let’s consider how poorly Warren Buffett has done in boom times.
As we all know, Mr. Buffett is a savvy investor who has consistently outperformed the market over the course of many decades and to the tune of many billions of dollars. I am not suggesting that any of us can match such consistent results. However, Mr. Buffett did not beat the market when investors were, on the whole, “irrationally exuberant.” In those years, he could have had superior returns by following an index. When those bubbles eventually burst, he came out on top. As he said, “Only when the tide goes out do you discover who’s been swimming naked.”
Mr. Buffett did relatively poorly while the market was high, but this came with increased downside protection at a later date. The obsession with matching the market, even when the market is irrational, is a flaw in the pure indexing strategy. It offers little to no downside protection.
There is financial and psychological data on the benefits of a more balanced approach, and you don’t need to be an oracle to find the right balance between ETFs and stocks.
Consider the Dividend Aristocrats. These large, well-established companies have increased their dividend payouts for the past 25 consecutive years. Admittedly, these companies change over time and, when they do, so should your portfolio. These firms, on the whole, have delivered long-term returns, often with superior downside protection in a bear market.
Another consideration is that of behavioral finance. (This is a separate field of finance, although I would argue that all finance is behavioral.) Studies have shown that investors who hold both ETFs and individual stocks are at a lower risk of selling during a panic because they feel a stronger connection to the companies they own. This engagement effect can keep people from acting against their own best interest during a market correction.
Portfolios Can Benefit From Individual Stocks
While still keeping the majority of your portfolio in broad market ETFs, there’s a benefit to having some skin in the game with a handful of positions in companies that you understand. Studies show that people who own a few stocks in addition to their ETFs will stay invested longer than those who own ETFs alone. ETFs can lead to us feeling detached from our investments, which I believe is one of many reasons people still invest in individual securities: the connection to the company.
Owning individual stocks is the only way to truly beat the market. Should you bank on this? Absolutely not. In fact, this is a good way to lose your entire nest egg, which is why a healthy percentage of your portfolio should be in ETFs. If you have the money to do so, however, adding individual stocks can lead to superior returns.
Those who have had positions in Apple, Google, and Amazon for the last twenty years feel pretty good about their investments. Likewise, you don’t find many people that regret owning Berkshire Hathaway. Financial planners often refer to this as a core-and-satellite approach: The index ETFs form the core, while carefully chosen individual stocks serve as satellites. Jim Cramer, in his most recent book, How to Make Money in Any Market, champions a similar approach, albeit in his own unique way.
To reiterate, your core position should be ETFs, and owning an index means you will hold those winners. However, overweighting those positions by buying individual stocks may lead to superior returns. But just buying what other investors are buying without knowing the fundamentals of the company is not a solid strategy. Nor is frequent trading, chasing trends, or panic selling. If you can pick the 4% of the stocks that created the net wealth in the U.S. stock market since 1926, then you may beat the index — but you have to hold them for decades.
Target Dividends and Quality for the Long Term
I favor diversification into dividend-paying blue chip stocks as well as companies with a strong balance sheet and a strong potential for growth that I, and ideally my clients, truly understand. This strategy gives us a sense of ownership and engagement, downside protection, and the potential for superior gains.
Furthermore, adding individual securities — high-quality stocks with proven track records, sound management, and a business plan you understand — isn’t innately reckless. Certain baskets of stocks, such as the Magnificent Seven, Dividend Aristocrats, and the Dogs of the Dow, have consistently outperformed and can offer protection in a down market as well as an attachment factor that an index fund may never achieve.
Bogle taught us to capture the market and stay the course. Buffett teaches us to understand our investments and hold for the long term. Ignoring individual stocks may reduce risk, but it may also reduce engagement, which could lead to reckless decisions. A wise investor can own both index funds and individual stocks, just in the right proportions and for adequate holding periods.
Wesley McBride, MD, CFP® is the head of new business development at the McBride Group LLC.
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References:
Shefrin, H., & Statman, M. (1984). Explaining investor preference for cash dividends. Journal of Financial Economics, 13(2), 253–282.
Hartzmark, S. M., & Solomon, D. H. (2019). The Dividend Disconnect. Journal of Finance, 74(5), 2159–2199.
Thaler, R. H. (1999). Mental accounting matters. Journal of Behavioral Decision Making, 12(3), 183–206.
Read more articles by Wes McBride
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
