Have you ever invested in a seemingly good stock only to have it lose you money?
This happens all too often: you invest in a high-quality company with great revenue and solid earnings growth, yet, one day something happens that totally hammers the stock price, taking your hard-earned cash with it. As a result, you’re now locked-in hoping for the price to recover so you can just get out without taking a big loss.
A recent example
Take Volkswagen for example. A seemingly great global company, reliable product, and solid earnings. Back on September 18, 2015, shareholders went to bed with a stock price of $161.36 per share and awoke to a massive emissions scandal and a stock price of $140.95. That’s a loss of more than 10% literally overnight!
By the next day it was as low as $105, and within a week was a mere $95. That’s nearly half your money gone in only 10 days! I don’t know about you but that’s not the type of thing I want to wake up to.
It’s now been 2 years and the stock price still hasn’t recovered to $161. Even worse, they had to cut their dividend payment down to $0.11/share from $4.80, so it’s not even paying shareholders a good price to wait it out.
VW isn’t the only example like this, history is littered with good stocks gone bad – Nortel, Blackberry, Bombardier, Valeant Pharmaceuticals, Enron, and we all know what happened to the US banks in 2008.
No matter how good of a company we think we're investing in there’s always the possibility of some type of scandal, corporate wrong-doing, bad press or new federal regulation that can turn things on a dime.
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How many individual stocks do you own?
If the answer is less than 40 you’re at a very high risk of suffering a big loss. Let me explain:
The average Canadian who invests within the stock market typically holds anywhere from 5 to 10 stocks.
JP Morgan (that big investment bank in the US), recently did a study that put the odds of a price decline of 70% or more in any one stock at 40% (the odds are even higher for riskier sectors like technology, mining, and biotech).
Essentially, any stock on the market, no matter how seemingly big and safe, has a 40% chance of suffering a catastrophic event that can reduce the price of the stock by 70% or more.
If you only own 10 stocks you can see how this can absolutely destroy your portfolio, setting you back years and potentially delaying retirement.
Even if only one of your stocks get's hammered, how many winners will it take to make up for a single loss of 70%? What if another 2008 rolls around and multiple stocks in your portfolio get hit at the same time? The last thing we want is to lose a huge chunk of cash and have to delay retirement.
You see, the difference between successful investors and the shirtless ones is not the ability to pick winning stocks or time the market, it’s the ability to minimize risk and preserve capital.
How many individual stocks SHOULD I own?
So, how many stocks do we need to own in order to diversify our risk to the point that we don’t get destroyed by a few bad apples?
Some say 20, others say 30, but a recent research paper titled, "How Many Stocks are Enough for Diversifying Canadian Institutional Portfolios?", showed that in order to be properly (and globally) diversified, and limit your risk to any single stock collapse, you need to own at least 40 stocks in Canada, 49 stocks in the US, 43 stocks in the UK, 38 stocks in Australia, and 39 stocks in Japan; for a grand total of 209.
Who in their right mind has time to manage all that?!
I know I certainly don’t. As you can see, it’s nearly impossible to keep up on enough stocks to effectively diversify your investments.
Remember, you also need to own stocks in other countries in order to get true, global diversification. You don’t want to have all your eggs in the Canadian basket – just look at how oil dragged down the Canadian market by -11% in 2015, while the US market (S&P 500) was down only -0.73% that same year.
What are your investment needs?
I got tired of picking well-managed companies only to still be at risk of emission scandals, crooked CEO’s, and shady accountants. I also wanted a way to buy stocks all over the world to get the benefit of a globally diversified portfolio without having to deal with currency exchanges or being awake at 2 am to trade stocks in Asia.
I figured there had to be a better way to diversify my portfolio and limit my risk to the forces I couldn’t control or predict.
Enter: the ETF
Now, you may have heard the word ETF, or maybe not, so let me quickly explain.
In it's simplest terms, an ETF (Exchange Traded Fund) is a type of investment that tracks/mimics a specific category of stocks by holding small amounts of each stock from that category.
An example would be a gold ETF that holds small amounts of stock from each of the top 50 gold companies on the stock market. An oil ETF might own shares from each of the top 30 oil & gas companies listed on the stock market. There are even ETF’s that own small amounts of shares from every company on the entire stock exchange, known as an Index ETF.
ETF’s trade like regular stocks on the stock exchange, letting you buy and sell whenever you want. The commission fee is the same as if you were buying a regular stock, typically around $9.99 every time you buy or sell shares.
Now, I know what you're thinking – "this sounds a lot like a mutual fund, and everyone says mutual funds are bad”.
Yes, mutual funds are bad because they charge loads of expensive fees and their performance is typically not very good. ETF’s, however, have incredibly low fees (as low as 0.05%). Furthermore, depending on the type of ETF you choose, performance doesn’t depend on some fund manager trying to pick winning stocks and “beat the market”.
For a more in-depth definition of ETF's here’s a great breakdown I found on Investopedia.
Why ETF’s are so great
As an ETF investor, you don’t have to worry about the day-to-day operations or news headlines from each individual company.
If you think the price of gold will go up over time, simply buy a gold ETF that owns all the top gold companies in North America. If you think the US stock market as a whole will do well this year, buy a US Index ETF that owns small amounts of shares in each company.
No more do you have to worry about some type of scandal or negative event that can destroy an individual stock price overnight – since ETF’s are so well diversified and hold so many various companies, this risk is essentially neutralized. (Not to mention the time you’ll save on researching each individual company!)
ETF’s let you invest in larger trends/categories rather than having to pick individual stocks, thus drastically increasing your odds of success.
Furthermore, unlike Nortel or Enron, it is nearly impossible for an ETF to go to $0 because that would require every company held in the ETF to also go to $0 – much safer than trying to pick a winning stock!
What if another market crash comes around?
If we look at the performance of ETF’s compared to stocks during the 2008 crash, not only did ETF’s go down significantly less than individual stocks, they recovered far quicker once the crash was over. Investors with ETF portfolio's simply waited it out and within one year were back in the money. People who owned individual stocks got hit hard, with many companies declaring bankruptcy and individual stock prices going to $0.
Some practical examples:
Let’s say you have $1,000 and want to invest in the Canadian stock market, but are unsure where to start. With over 240 individual stocks on the Canadian Stock Exchange, this can seem like a daunting task. If you’re like me, your criteria is simple:
- You want something that will represent Canada as a whole and follow the entire Canadian market.
- You want something that will pay you some extra cash in the form of dividends while you wait for the price to rise.
- You want something that will manage itself without you having to keep up on news headlines and earnings reports.
One example of an ETF that meets our requirements is called XIC by iShares.
You can buy XIC just like a regular stock in your online account. It lets you own the entire Canadian stock market by holding small amounts of each of the 248 listed companies. It has an incredibly low cost of only 0.06%, and you can leave it in your trading account indefinitely without having to worry about tracking each companies performance – a great option for those seeking a set-it-and-forget-it (passive) investing strategy.
You can see the total percentage of each stock that is included in the ETF as well as the types of categories that it covers (i.e. Financials, Energy, Utilities, Telecom, etc). Some ETF's hold equal amounts of each stock, whereas others (like XIC) hold a heavier concentration (known as a weighting) in the sectors that the ETF manager feels will have the best performance.
Remember, according to our research study, it takes a minimum of 40 stocks to be properly diversified in Canada. With an index ETF like XIC, we can own 248 stocks and be incredibly well diversified (as well as save almost $400 on trade commissions!).
What about global diversification?
Ok, so we’ve got Canada covered, but what about other regions like the US, Europe, and Asia?
There are nearly a dozen ETF providers in Canada offering hundreds of options. Some ETF's are very specialized (ex. junior mining companies), whereas others are quite broad (ex. an Index ETF covering every company on the entire stock exchange).
Without having to exchange any currency, there are ETF’s like XSP by iShares that own a diversified basket of the 500 biggest US companies. XSP is traded with Canadian dollars on the Canadian stock exchange and can be bought like a regular stock through your online trading account.
The ETF ZDM by BMO holds hundreds of stocks in pretty much every developed country outside of Canada, including Japan, the UK, France, and Germany. Again, it trades on the Canadian stock exchange and in Canadian dollars.
Best of all, each of these ETF’s can be held in your RRSP or TFSA in order to shelter your gains (and dividends) from tax!
Key takeaway: when investing, always focus on minimizing risk and preserving capital, not swinging for the fences with speculative stock picks.
To get proper diversification it is incredibly unrealistic to successfully manage dozens of individual stocks in various countries, and it's only a matter of time before one of your picks suffers a major loss that wipes out the gains of any winners. Sure, holding individual stocks may save you a few dollars on fees but think of the fees as insurance for your portfolio.
By far the most effective way to get a truly globally diversified portfolio is through the use of low-cost ETF’s. With only a handful of ETF’s, you can literally own hundreds of companies world-wide and reduce your risk of accidentally owning the next Nortel, or Volkswagen. Be proactive in protecting your hard-earned nest egg; don't get stuck waiting years for it to recover after the next stock market crash.
Do you prefer ETF's or individual stocks? Let me know in the comments below and tell me WHY.
One last note
I’ve only set the stage with a very high-level summary of ETF investing, however, I hope it will give you a better idea of the strategies available to protect yourself against losing money in the markets. Please continue to broaden your knowledge on investing and ETF’s, and be sure to check back often as I review more strategies and tactics to help build your wealth.
Before you invest be sure to register for my Building a Bulletproof Portfolio investing workshop, and get the complete guide on How I built a winning portfolio that sailed through the 2008 stock market crash without losing a dime.
Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions.