It's not true that passive investors should avoid individual stocks.
It's not true that investing in individual stocks requires special skills or lots of time.
It's not true that owning passive index ETFs is the only way to be a passive investor.
If you want to own individual stocks, you need to study as many aspects of the business as you can, read quarterly reports, and analyst opinions and stay abreast of company news. If you don't have the time or interest in doing so, then you should own passive index ETFs and skip individual shares altogether.
Sound familiar? Sound about right to you?
You can buy a well-diversified collection of individual stocks and then literally ignore the companies entirely. And if you own individual stocks, maybe you SHOULD ignore them. The problem is that if you study the companies you own, you are going to be tempted to... do things. When it comes to investing, doing things is bad. Every single decision you make is literally nothing more than another chance to screw up and lose your money. Human beings stink at investment decisions. You stink at investment decisions. The solution to this problem is easy: just don't make decisions. Once you buy a diversified portfolio of stock, go do something different.
Should you stay informed about your investments? If your plan is to never act on that information ever for any reason, the answer is "no." Information is useless to those who intend not to act on it.
Do you ever wonder why most fund managers produce horrible investment results? It's not because they are dumb, or don't have access to information. It's because they need to do things. Why hire and pay them otherwise? Thankfully, you do NOT need to do things. The smart fund managers wish that they had your ability to buy and hold a diversified portfolio of stocks in complete, utter ignorance of what the companies you own are doing.
On to the next question. Why shouldn't you own a passive index ETF? I'll turn the question right back at you. Why wouldn't you skip that entire "index" layer and go straight to owning some or all of the individual stocks that the index ETF owns? Business 101: cut out the middleman! What's wrong with doing that for your portfolio?
Most people are told to own index ETFs because then, you can (and should) ignore the stock market AND ignore whatever is happening with the companies in the index. So why does that change if you own the index's underlying shares directly? Totally bogus argument. Ignore stocks if you want to ignore stocks, whether they're in a passive index ETF wrapper or you own a diverse portfolio of those same stocks directly.
Here's another line you've heard a million times. You need an index ETF because the stock index composition changes over time. Indexes get rebalanced. Companies cease to meet the index criteria. The index ETF does all that stuff for you. Fine, but that's not passive investing. Rebalancing means doing things.
Did any of you ever watch that show Seinfeld? It's a TV show about some people making a TV show about themselves, and the character George Costanza tries to pitch the TV show as "a show about nothing." How about an ETF about nothing? The fund sponsor picks a static, well-diversified portfolio of shares, switches off the lights as she leaves the office, and is never heard from again. The ETF has no strategy - it doesn't need one because it doesn't do anything (other than hold the originally selected stocks and spit out any dividends to shareholders). If that sounds about right to you, read on.
Obviously, nobody on Wall Street would ever create a fund like that. Wall Street is about getting people to pay you for doing things, and who is going to pay a sponsor for creating an ETF about nothing? But you don't care because you don't NEED Wall Street to get what you want. You can create your own ETF about nothing.
What are some other reasons to own a passive index ETF instead of going straight for the underlying stocks? Well, it used to be expensive to buy individual stocks, and you could save brokerage commissions if you owned an index fund. That's not so true anymore. In fact, some platforms enable investors to buy stock for free. The commissions other platforms charge for buying and selling stocks are collapsing as we speak. It's cheap to build your own passive stock index by owning individual shares of stock. Times changed.
What if you don't have enough capital to buy every share of stock in an index like the Dow Jones? An index ETF will get you there right off the bat. True, but there are other ways to get you there, too. You could just buy one share at a time when you have the money, working your way down the list till you've hit them all. Then start again from the top. Repeat for rest of life.
Somehow, it's hard to bring yourself to believe that doing literally nothing with your investments is a smart strategy. Even if you do believe in doing nothing, you end up feeling the urge to do nothing... with a twist. It takes tremendous discipline to avoid adding bells and whistles to a "do nothing" investment plan.
Here is a true story. I happen to know a certain investor (who is no doubt reading this article right now and chuckling to himself) who owns a small but diversified portfolio of a few companies that he inherited decades ago. I don't think he has ever read even one single annual report from any of them. He's too busy outside or down in his basement building chairs and reading 800 page books about wood varnish. His portfolio performance probably rivals George Soros'. Not a surprise, because he's got a huge edge on Soros. This certain investor can afford to stay 100% out of his own way. 100% passive strategy, straight up with no twist.
Do you want to know how I picked lots of the stocks I own? I'll tell you. I'm not proud. I stole the information. I like dividends, so I pulled the portfolio holdings for a few dividend growth ETFs like the iShares Select Dividend ETF (NASDAQ:DVY) and Vanguard Dividend Growth ETF (NYSEARCA:VIG). They publish an updated list for free on their websites. At the time, I felt that I wanted to own businesses, not an investment strategy or some kind of intermediary I didn't totally understand (and I still don't really understand more than just the basics of what VIG, DVY, SDY and those funds actually do). So I plucked a few companies out of each of the different economic sectors (energy, transports, utilities, pharma, consumer, financial, etc.), bought the shares and created my own mini dividend growth ETF (minus the ETF management fees, of course). I've done way less selling than any of these funds (and made better money, too).
I got curious today, and I looked at the holdings for DVY circa September 28, 2012. I decided to do a little experiment. I picked their top 10 holdings from the 10 different industries they invest in (highlighted in yellow). Together, these 10 stocks account for about 20% of DVY's total portfolio as of 2012. Here is the list, pruned from the spreadsheet I pulled off its website (iShares):
Okay, what I am doing here is one step away from putting on a blindfold and throwing darts. I have no idea what some of these companies do (and I definitely had no idea in 2012, either). I don't remember what any of these companies was doing in 2012, so picking these things almost randomly by walking down a list of companies in an index is literally what's going on here.
Suppose I bought $10,000 apiece of each of these 10 stocks on September 28, 2012, and did literally nothing other than reinvesting all the dividends back into more shares. This is my own hypothetical Dividend ETF About Nothing that I held from September 28, 2012, to today. What would my investment performance look like?
I went to Dividendchannel.com and used its DRIP calculator. It's a glorious tool. You can use it too - here is the link: Cool Drip Calculator. Here is what I calculated:
That's a total return of 114% almost. And how did the Dividend ETF About Nothing perform compared to DVY itself? Let me give you a hint. DVY does not own these same shares in these same proportions any longer. Unlike the Dividend ETF About Nothing, DVY has been doing things.
According to Dividendchannel.com, a $100,000 investment in DVY from September 28, 2012, to today, with all dividends reinvested, would be worth $198,419. That's a 98% return. The ETF About Nothing comprised of stocks I don't know much about and never followed closely outperforms the broader "passive" index by a wide margin.
Why? Management fees? Portfolio churning? Equal weighting? Luck? I assure you that I have no idea - one data point doesn't come close to answering that question, which is totally beside the point, anyway. The point is that if you pick a reasonably balanced and diversified portfolio of individual stocks, you don't need to be an expert stock picker or hang on every single piece of news about each company you own. You don't need to play the same game as a professional fund manager, or buy into the line that Wall Street is selling everyone, which is that individuals should eschew stocks and own index ETFs instead. I'm not saying you will do better, or even as well by owning individual stocks instead of index ETFs. What I am saying is that if you want the most passive portfolio theoretically possible, you can (and indeed, must) do it yourself by owning stocks directly and then have the discipline to not do things. Just be well diversified, and disciplined about not trying to play rigged games - such as trading.
The article is over, so you can stop reading now. But some who follow me are probably wondering "but hey, you read stock news all day."
Answer: That's because I like it. It probably doesn't help me to do that.
Some of you are asking "but hey, you buy and sell stocks all the time!"
Answer: I do a lot of dumb stuff - and not just with money. Plus, I'm not a passive investor. Doesn't mean you can't be.
Disclosure: I am/we are long LMT, MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This is the farthest thing from investment advice that could exist. Every single expert financial adviser you ever show this to will say I am a moron. If an ETF sponsor saw this, they'd track me down in Lisbon and say mean things to me. Rely on nothing I say for any reason. Do your own thinking, make your own decisions.