Should I Invest in ETFs First Before Individual Stocks?

Starting out, the idea of investing in ETFs before individual stocks is not a bad one. This article explores the pros and cons of both approaches, helping you decide based on your financial goals, time horizon, and business acumen.

Introduction to ETFs: A Safer Starting Point

For many investors, especially those new to the market, it often makes sense to start with Exchange-Traded Funds (ETFs) before diving into individual stocks. One example is investing in the SP VFAIX, which I held for 40 years leading to an early retirement, or using the VGT Technology ETF, which has a strong long-term performance record. You can also continue to invest in individual stocks as you gain more knowledge and confidence.

The Benefits of ETFs

ETFs, especially broad-market ETFs, provide a cushion against individual stock volatility. When you focus on individual stocks, you have to invest more time and effort to understand the company, its business model, and market conditions. This approach involves a higher level of risk, but also the potential for higher rewards. However, for a more laid-back strategy, you can opt for ETFs, which offer instant diversification and lower volatility.

One notable drawback, especially with focused ETFs, is that they can sometimes mirror the volatility of individual stocks. But the broader advantage of ETFs is their ability to participate in the economic growth of the country with consistent, lower-risk investments. You should be prepared to weather crashes and pullbacks, but remember that you don’t lose if you don’t sell.

Long-Term Investment Strategy with ETFs

If your time horizon is long term, meaning decades, and you have limited time to dedicate to portfolio management, you could benefit from a passive investment strategy using low-cost ETFs, such as those from Vanguard. By investing in major US indexes consistently, you can benefit from compounding and long-term gains. This strategy ensures you participate in the general economic growth, albeit with the potential for losses during market downturns.

The key to success is staying invested as opposed to trying to “time the market.” The historical data supports the idea that long-term investors generally fare well, as illustrated in charts showing the performance of an ETF indexed to the SP 500 over time.

ETFs for Diversification and Specialization

ETFs come in two primary types: those that track broad indexes and those that focus on specific market segments. Broad ETFs, like the SP 500 or Russell 2000, are a passive investment in a wide variety of stocks. On the other hand, specialized ETFs, such as those focused on biotechnology or electric vehicles, may offer higher returns but come with increased risk.

To diversify your portfolio, consider spreading your investments across different types of ETFs, such as US large-cap and small-cap ETFs, as well as exposure to emerging markets. Each investor can tailor their allocation based on their financial goals and risk tolerance, with common allocations ranging from 50-30-20 to 60-20-20.

Conclusion: Balancing ETFs and Individual Stocks

Ultimately, the choice between ETFs and individual stocks depends on your overall investment strategy, time horizon, and risk tolerance. While ETFs offer a safer, more diversified approach, individual stocks can offer higher returns if you’re willing to put in the research and time.

Additional Considerations

Note that the performance of ETFs can vary based on the index they track, their construction, and whether they are actively or passively managed. Actively managed ETFs require ongoing attention from managers to ensure optimal allocation and performance.

I follow my own version of this advice: a mix of ETFs, low-cost index funds, high-dividend stocks, and promising future investments. However, this approach is best suited for those with ample time to track and manage their portfolios.