SAN DIEGO (ETFguide.com) - Over the past year and a half global
equities haven risen sharply but millions of investors still
have a portfolio of stocks doing nothing. Either they've owned
underperforming companies or even worse, ones that have been
driven to bankruptcy.
How can you minimize your risk to individual stocks? One
strategy is to own ETFs that own a broad group of stocks instead of
betting your future on just one individual company.
In this regard, ETFs can be successfully substituted in the
place of individual stocks from three angles: 1) Market size, 2)
Investing style and 3) Industry sector.
Let's analyze each strategy.
What do Best Buy (
), McDonald's (
) and Starbucks (NasdaqGS: SBUX) all have in common? Not only are
they recognized consumer brands but they are all large company
stocks. Which ones do you buy?
The stock replacement strategy solves the investor's dilemma of
which stocks to buy. Since stocks come in three general sizes
(Large cap, mid cap and small cap) simply owning a corresponding
ETF to match your desired market size accomplishes your
Large cap ETFs like the iShares Russell 1000 (NYSEArca: IWB) or
the Vanguard Large Cap ETF (NYSEArca: VV) can be substituted in the
place of stocks like Best Buy, McDonald's and Starbucks. For mid
and smaller sized stocks, substitutes like the SPDR S&P MidCap
400 ETF (NYSEArca: MDY) and the Vanguard Small Cap ETF (NYSEArca:
VB) can help you to execute your stock replacement strategy.
Virtually any publicly traded stock can easily be substituted
with an ETF that matches its market size.
Growth and Value
Another defining characteristic of stocks is whether they are
growth or value oriented companies. Generally, stocks with no
dividends, faster growing earnings and higher P/E ratios are
considered growth stocks. Conversely, stocks with higher dividends,
steady earnings and lower P/E ratios are generally categorized as
What's better? Growth or value stocks? It's really a matter of
preference, but here too, ETFs can be substituted in the place of
Instead of banking your fortunes on a single growth stock like
Amazon.com (NasdaqGS: AMZN), growth ETFs like the iShares Russell
1000 Growth ETF (NYSEArca: IWF) or the Vanguard Large Growth ETF (
) allow you to bank on a group of growth stocks with similar growth
characteristics to Amazon.com.
Let's suppose you're bullish on the future prospects of the energy
sector. You don't need to buy Chevron (
), Exxon Mobil (
) or some other energy stock to participate. The stock replacement
strategy allows you to invest in energy related ETFs that own a
group of energy stocks. Furthermore, some of these very energy ETFs
may even own CVX or XOM!
Corresponding substitutes for CVX or XOM would be the Sector
Energy ETF (NYSEArca: XLE) or the SPDR S&P Oil & Gas ETF
The stock replacement strategy works well for just about any
stock and its matching industry sector.
Using the Replacement Strategy
The most obvious benefit of the stock replacement strategy is
portfolio diversification. In other words, you reduce your
financial risk to individual companies by owning a group of
companies via a diversified portfolio. Got it?
Interestingly, this is one of the most overlooked secrets of
successful investing. It isn't so much about picking the right
stocks, as it is avoiding disasters. Even stocks that are doing
well are susceptible to unexpected blowups that not even the best
or most intensive stock research can prepare you for. (See Goldman
Sachs (GS), BP, PLC (BP) and Toyota Motors (TM))
How long would it take you to build a diversified portfolio of
500 to 1,000 stocks? Before you could finish, the trading costs
would likely bankrupt you. Instead of trying to build an investment
portfolio one brick at a time, using ETFs can help you to
accomplish your goal.
Besides helping you to minimize financial risk, the stock
replacement strategy can help you one last way.
Investment study after investment study continues to prove the
vast majority of stock portfolios (both amateur and professionally
managed) consistently underperform corresponding index funds or
index ETFs. What does that mean?
Simply put, by owning a portfolio built upon index ETFs you can
avoid all of that chronic underperformance. You also avoid the
higher investment costs associated with those losing
In summary, the stock replacement strategy can be a win-win for