The most difficult aspect of investing in stocks for most businesspersons, beginners and experienced investors is stock selection. The most popular options you may face in stock selection are value stocks, mutual funds and ETFs.
In value investing, the investor identifies undervalued stocks that are trading below their intrinsic value, then buys, and holds them until the market reflects their fair value.
In ETF investing, the investor buys an index fund or index ETF and tries to replicate the performance of a major market index. When the average goes down, so does the fund and vice versa.
So how is value investing safer than ETF investing? Is stock picking not riskier?
The answer is: yes! It can be, but only if you don’t know what you are doing. A true value investor knows that the stock market is an irrational place, prone to constant mispricing of companies to exploit.
Here are 5 reasons why I think value investing is safer than ETF investing.
High Margin of Safety
When looking for the ideal stocks to invest in, an investor should evaluate the margin of safety to determine their relative risk. Volatility is widely feared in the stock market as a major investment risk, and when it occurs, ETF investors can panic.
It can quickly throw investors out of the market or lead to large losses. Value investors, however, are hardly affected by this because they understand that price volatility does not equate to risk.
A value investor buys shares that are trading at a significant discount to their intrinsic value. This difference between the intrinsic value and the purchase price is called the margin of safety.
Undervalued stocks have a high margin of safety; therefore, investors do not suffer panic, losses and market uncertainty during volatility. Conversely, they get the opportunity to buy more shares at a lower price, thus increasing the margin of safety of their shares.
Volatility is your friend! Let it reward you.
Unlimited access to strategies
There are many strategies in the stock market that investors can use and combine to create a portfolio that is better suited to their personal goals and offer better risk-adjusted returns.
With proper research and investigation, you can find the corners of the markets that are undervalued. After researching, you can combine these stocks into a smaller, more targeted portfolio.
For instance, you can find many undervalued companies that pay a higher dividend than the index. If you use this strategy and buy the stock, you can rake in an extra return on your investment while you wait for the dividend to come due. Take a look at Church & Dwight Co., Inc., as an example:
By taking advantage of the market's price fluctuations, the dividend of such companies can be a nice icing on the cake.
Index funds allow investors to diversify strategies to build a portfolio. However, buying an index does not give you access to these companies. Most investors are limited to using only a few strategies. As a result, their ability to generate risk-adjusted returns is minimal compared to value investors.
Potential for massive returns
Since value stocks are bought when they are trading below their intrinsic value, the investor has the option to sell the stock at a time when it is trading at or above its true value.
Undervalued stocks have the potential to generate exponential gains over time if they manage to turn around. Value investing is about waiting out short-term market fluctuations to generate long-term returns.
On the other hand, index funds do not have the potential to outperform the market the way value equity funds can. When you invest in an index fund, you give up the possibility of massive gains.
Unlike value equity funds, where underperforming years are offset by outperforming years, the performance of index funds remains constant over time and this means there is no chance of exponential gains.
Control over the shares
Value investing is a safe option for investors because it gives them control over individual holdings. If you don’t like a particular company for moral or personal reasons, you simply do not have to invest in it. There are thousands of companies to choose from!
With value investing, you can choose how many companies you want in your portfolio. You can choose the weighting, exposure, timing, etc. You manage your money.
With ETF investing, the investor has no control over these options, making it less flexible for those who want to control their own holdings. The brokerage firm and the index as a whole, which can pose potential risks to your portfolio, control Index funds.
In fact, it has been proven many times that a small concentrated portfolio of about 10 good companies can outperform an index. For investors who know what they are doing, it is the exact method Warren Buffett recommends. In fact, he even considers diversification (as in an index fund) to be a hindrance to a portfolio. On the other hand, Buffett also recommends ETFs for those who don’t know what they are doing.
For a value investor who knows and understands the companies he owns, index funds simply do not provide the control he needs.
Investing in value stocks requires patience, as your shares are ultimately unaffected by daily market fluctuations. As mentioned earlier, value investing requires investors to know the companies they own intimately. If you know the value of a stock, then daily market prices will hardly affect you.
Value investors sleep well at night and do not care what the market does from day to day. Developing a rational plan for price fluctuations allows value investors to reap the benefits of high returns with low risk.
Although index funds are a long-term investment, an investor has no control over what flows in and out of the index. As a result, you don’t get the satisfaction of knowing why your stock price fluctuates up or down. You may not even know which stock caused the fund to go down!
Value investing is a viable and safer option for investors in the stock market compared to ETF investing. The caveat here is that value investors need to know what they are doing.
If you want to outperform the index, you need to spend the time to research and know the companies behind the stocks you are buying. Once you have done the research and know the company, simply invest in undervalued stocks of your choice and watch them generate spectacular profits in the long term.
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