In this episode I take a look at DIY dividend investing versus investing in ETFs. I explore the advantages and disadvantages of investing in ETFs.
Also covered in this episode:
- The Simply Investing Approach
- What are ETFs?
- 4 issues with ETFs
- Are ETFs for you?
- What's the solution?
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In this episode we're going to look at the advantages and disadvantages of investing in ETFs. Hi, my name is Kat Walserai and welcome to the Simply Investing Dividend Podcast. In this episode we're going to cover four topics. So we're going to start off with the Simply Investing approach, then we'll talk about what exactly are ETFs, then we'll look at the four issues with investing in ETFs and then we'll take a look at if ETFs are for you and then we'll look at another possible solution. So let's get started with our first topic, the Simply Investing approach. So our approach at Simply Investing, and what I've been teaching for over the last 20 years, has been how to invest safely and reliably in dividend stocks for the long term, regardless of what happens in the stock market and regardless of stock prices going up and down, because they do go up and down all the time. So how do we invest safely and reliably for the long term? Well, we do that by investing in quality dividend stocks when they are priced low. So not just any stock. It has to be a dividend stock and not just any dividend stock. It has to be a high quality stock and we don't invest just at any price, but when prices are low for a specific stock that we're looking at investing in. Like I said before, stock prices go up and down all the time. So you want to invest when the stock is priced low. We call that undervalued. We do not want to invest in a stock when it's priced high, and we call that overvalued. So how do you know, when you're looking at a stock, if it's a quality stock and if it's priced low? So for that, I've created what I call the 12 rules of simply investing. You can see the rules up on the screen right now and we're going to go through these first and then we'll move on to our next topic. Now think of this as your checklist. There's 12 rules up on the screen. This is your checklist. A company must pass all of these rules before you invest in it. So not just passing maybe nine out of the 12 rules or eight out of the 12, it has to pass all of the 12 rules. If there's even one failure, skip it, move on to another company. Okay, so the simply investing approach is designed to lower your risk and maximize your returns. I've been using it for over 20 years and I've been teaching it for a very long time. So let's take a look at rule number one. Do you understand how the company is making money? If you don't skip it, move on to something else. Rule number two 20 years from now, will people still need its products and services? Remember, we're investing for the long term, so we want to make sure that the company is going to be around for a very long time and, especially if you're starting off young, you are going to be investing for the next 20, 30, 40, 50 years and you want to make sure that your investment is growing and it's still there 30, 40 years from now. Rule number three does the company have a low cost competitive advantage? Rule number four is the company recession proof, right? So think about this If there's a recession or there's a chance you may lose your job, you're not going to go out and buy a new car. You're not going to take a vacation and expensive vacation overseas. So just for that reason alone, we don't invest in car companies or invest in airlines. So rule number four is the company recession proof. So keep that in mind. Rule number five is the company profitable? Right? We want to invest in companies that are consistently profitable. That we look at in the 12 rules. We look at the last 20 years. So we want to look at the last 20 year average earnings growth and we want to see the earnings going up consistently. Again, you're investing your hard earned money into this company or in the stock, and so we don't want to invest in companies that are losing money, because the value of the stock is going to come down, which the price of the stock is going to come down, which means the value of your investment is going to go down. So, rule number five take a look at to make sure the company is profitable. Rule number six does the company grow its dividend Right? So remember, the dividend is the cash coming into your pocket. It's the company sharing its profits with you, the shareholder. The dividend is basically, essentially cash that gets deposited directly into your trading account. So that is your dividend income, that is the income being generated from the portfolio and we want that dividend income to grow because, at the end of the day, hopefully, the dividend is going to cover your living expenses. So, rule number six make sure that the company is growing its dividend consistently, because the more it grows its dividend, that's more money in your pocket. Rule number seven can the company afford to pay the dividend. If they can't skip it, move on to something else. Rule number eight is the debt less than 70%? Right, we don't want to invest in companies that have a debt of like 700, 800, 900%, because when there is the next recession or the next market downturn or interest rates go up, those companies that are carrying a lot of debt are going to have a very hard time paying off that debt or even making the interest payments. So those are the companies that are going to struggle and we want to avoid investing in those companies. So rule number eight we want to take a look at the company's debt level and make sure that it's 70% or less. Rule number nine avoid companies that have had a recent dividend cut, because that is negative for the company. When the company cuts the dividend, the share price comes down, and so we don't want that. The opposite of that is to make sure that the dividend is going up consistently over time, and that was rule number six, which was to make sure that the dividend is growing Okay. Rule number 10, does the company buy back its own shares? Rule number 11, is the stock priced low? So I talked about that earlier. We want to invest in companies. When the share price is low, the stock is undervalued. It doesn't mean it's a bad stock. It means, for A number of reasons, stock prices go up and down all the time and good quality companies can also get dragged down when the market is down or if their industry is down. So we want to be able to purchase stocks when the price is low. So rule number 11 is in three parts. So we look at the PE ratio. We want to make sure it's low. Number two, we look at the company's current dividend yield and we compare to its 20 year average dividend yield. And the third part is we look at the PB ratio, the price to book ratio, and we want to make sure that's low as well. So if all three conditions are met, then the company will pass rule 11 and then we know that the company is priced low. So remember, we're looking at quality companies, but we also want to make sure that the price is low. And then rule number 12, keep your emotions out of investing. I know that's easier said than done. It is very challenging, especially when it's your hard-earned money and when stock prices go up and down. It can become a bit of a roller coaster ride, but you have to keep your emotions out of investing. This is where the 12 rules come in handy. This is your checklist. So, regardless of how you feel about a stock or how you feel which way the market is going, just follow the 12 rules, follow the checklist and, like I said, these rules are designed to minimize your risk, maximize your returns over the long term. So this is our approach to investing. So, when it comes to investing in individual stocks, in selecting the right stocks, we always refer back to the 12 rules and, like I said in the beginning, if a company fails even one rule, we skip it and move on to something else. So this is my approach, this is what I advocate, this is what I practice myself for over two decades and this is what I've been teaching for a very long time. However, there are individuals and I know, especially with the fund companies as well that there's a big push to not do any of this what you see on the screen but to put the money into mutual funds, index funds and ETFs. So today's episode, we're going to focus on ETFs and we're going to look at some of the disadvantages and some of the advantages, if there are any, of investing in ETFs. So let's move on to our second topic in this episode. What exactly are ETFs? So ETF stands for exchange traded fund. So this is what it looks like, and it's similar to a mutual fund or index fund, where you have a fund company and you, as the investor, is going to give your money to the fund company to invest on your behalf and it's not just you, there's many, many other investors. So all of these investors give their money to the fund company. The company then takes that money and invests it on your behalf, and it could be in a mutual fund, it could be in an index fund or in an ETF. Now you get to decide. Of course, when you put your money with the company, you get to decide which type of investment you want to invest in. At the end of the day, the company is going to take that money from all the investors and invest it in stocks on your behalf. So, whether you like it or not, you're still investing in the stock market and you're still investing in stocks. Now you can do it yourself individually, pick which stocks to invest in, or you can give your money over to a fund company and they will turn around and invest it on your behalf in stocks. Now, with a mutual fund, there is a fund manager. The fund manager decides when to buy, when to sell, decides which stocks to buy, which ones to hold. So because of that, mutual funds generally have a higher fee, an annual fee, that you have to pay. An index fund generally there's no manager. It's going to buy automatically whatever stocks are in that index. So we've got different indexes. We have indexes, basically a list, a list of stocks. So if we have a SNMP 500 index, that means it's the top 500 companies in the US and it's just a big list of 500 companies Start with the biggest one, go to the next one, next, next, next, next, next An index fund. So when you invest in that, so if you put a thousand dollars in an index fund, it's basically taking your thousand dollars, divvying it up amongst 500 companies and you're buying small portions in those companies. An ETF is exactly almost like an index fund. That's what it says on the screen here. It says an ETF is a type of fund that owns a collection of stocks Right, and it's tracking the underlying index. So it could be like I said, the SNMP 500, which is a list of 500 companies. It could be a list of dividend stocks, so it could be a few hundred in that list. Then a dividend ETF is only going to invest in those few hundred dividend companies. So ETFs are essentially similar to an index fund. However, etfs are listed on stock exchanges and their shares an ETF itself is a share trades throughout the day just like an ordinary stock, which means, like I said before, stock prices go up and down. Etfs go up and down as well. They're just like stocks. They trade on the stock market and their prices go up and down. Now the benefit here is you can sell the ETF immediately. I mean, when the stock market is open, you can put an order to sell and whatever the ETF share prices, it will sell for that price. So ETFs can hold anywhere from a few hundred to a few thousand types of different stocks or different companies. It depends on what is in the index in that list. So, like I said, snmp 500 is going to hold 500 companies in that index or in that ETF. If it's a dividend stocks or blue chip dividend stocks, well then there's not going to be thousands. If we're talking about just in the US, there's just going to be maybe a couple of hundred, maybe 50, right? So that's going to be in that index. So it'll range anywhere from a few hundred to thousands of stocks that are held within an ETF. Here on the screen you can see some examples of ETFs. There's hundreds of ETFs probably more than that all over the world to choose from. So on the screen you can see the Vanguard dividend appreciation ETF. The symbol is VIG. Because they trade on the stock market, they have, just like stocks, stock symbols. We have the iShares core dividend growth. We have the Schwab US dividend equity and then another iShares select dividend. But I've only given you four examples on the screen. Like I said, there are hundreds and hundreds of ETFs to choose from. Okay, let's move on to our next topic. What are my four issues with ETFs? Okay, we're going to talk about some of the disadvantages first. So issue number one with ETFs, you are inadvertently investing in stocks that are priced high. So think about this for a moment An ETF, like I said before, can own hundreds or thousands of stocks of companies within that ETF and on any given day, not all of those companies in that index are priced low. Some of them are priced high. They're overpriced, overvalued. Some of them might be priced low, but there are a mix of overvalued and undervalued stocks in that ETF. So if you were to put $5,000 down or $1,000 down or even $100,000 in an ETF today, you would inadvertently be investing in stocks that are priced high, and that violates our simply investing rule number 11. Remember, we only want to buy stocks, we only want to invest in stocks when they are priced low. So if a company is failing rule number 11, skip it, move on to something else. But if you're investing in an ETF or an index fund or a mutual fund, you are then violating rule number 11. Even when the market is down, there are going to be individual stocks that could be priced high, and so we don't want to invest in those. Right, I've had people say well, I only invest in ETFs when the stock market is down. Well, how do you know the stock market is down? Will it go down further next week, next month, next year? It is very difficult to know. It is very difficult to time. We don't time the stock market, we don't time exactly when to invest. So that's why rule number 11 is important. And that's my first issue. With ETFs, you are inadvertently buying stocks when they're priced high and that is going to hurt your portfolio, the performance of your portfolio, in the long term. Issue number two with ETFs, you are inadvertently investing in non-quality stocks. So think about this it's the same thing With an ETF or an index fund or a mutual fund. There are hundreds or thousands of companies within that fund and on any given day, there's going to be companies in there that are failing some of the 12 rules of simply investing. There's companies in there where the debt is going to be too high 500, 600, 900 percent. There's going to be companies where the payout ratio is too high. There are companies in there that don't pay dividends. There are companies in there that might be cutting their dividend or have cut their dividend recently, and so, as individual as I was going to say DIY investors we would never invest in those companies. So if you would never invest in a company that has a debt of 800 percent, why would you buy that company through an index fund or an ETF? So what we're looking here and what I'm talking about with issue number two is you're inadvertently buying companies that are failing some of the 12 rules, if not all of the 12 rules, because, again, there's so many stocks in that index. So I would rather go in myself and individually select the high quality stocks, meaning the companies that pass the 12 rules of simply investing, because that is a high quality stock. So that's my second biggest issue with ETFs Because, again, when you're buying companies that are not high quality, that is going to hurt the performance of your portfolio in the long run. Issue number three with ETFs, you cannot control which stocks are held in the fund. I already mentioned that. That was an issue number one. Issue number two Because that's out of your control. You have no choice. Again, if you're investing $1,000, $100, or $10,000 or $100,000 into an index fund, the company the fund company is going to choose those stocks on your behalf. Whether they choose them through a fund manager or through an index, they are doing that. So let me give you an example, a real life example. So, for example, ge used to be in the Dow Jones index. Right, the Dow Jones Industrial Index. It's a list of 30 companies. Ge used to be in the Dow Jones index. Ge used to be in that index. Now, most investors dividend investors sold the stock after the second dividend cut Because GE had been consistently losing money and the company was shrinking. They had a number of layoffs, they sold off bits and pieces of the company and they started to cut the dividend. So after the second dividend cut a lot of dividend, investors just sold the GE. They cut their losses and said we're done. However, ge remained in the index, which means it remained in any ETFs that were following that index for another 12 to 24 months, and so by the time GE was removed from the index, its stock price had dropped considerably. Okay, so when you're investing in individual stocks on your own, you can pick and choose which companies you want to keep, and you can pick and choose which companies you want to sell, because you can apply the 12 rules and you can say, okay, well, this was a good company. When I bought it years ago. It was fine, but now they're having a lot of issues. The debt is very high, the dividend is getting reduced, the payout ratio is very high, the dividend is at risk, it might get cut again, and then you have to make a decision and I've got episodes on this on when to sell, and so you could do that. But if you've purchased an ETF or an index fund, you cannot pick and choose which stocks to remove. As long as they remain in the index, as long as the fund company wants to hold on to them, well then, you're still invested in those companies Again, companies that might be priced high, companies that might be of low quality, and you still end up owning them. Now issue number four, and this is a big one. They're all very important, but this is also a very big one. With issue number four, you are still paying an annual fee. It's the same with mutual funds, index funds and ETFs. They all carry an annual fee. It's called the management expense ratio, the MER. The fee is there to pay for the company's overhead of managing this fund. So they have to pay their staff. They have to pay their fund manager. In the case of ETFs or index funds, there is no fund manager, but there is still overhead in managing all the money from all the investors and sending out annual statements, whether it's by mail or online. Somebody has to make those statements and all of this has to be managed. So there is overhead, and so all ETFs carry a fee. Now you don't pay the fee directly. It's automatically taken out of your portfolio every single year. So let me give you an example. If we're looking at a SNMP 500 index fund. So this fund owns the 500 biggest companies in the US. Let's say it has a fee of 2%, so MER of 2%. This is an annual fee. And let's say the stock market in one year returned 5%. So not that great, it's okay 5%. The stock market had a 5% return, while your statement at the end of the year from the fund company is going to indicate that your portfolio performed at a 3% return. Now you might be wondering why did you only make 3% return when the stock market had a 5% return? Well, you can see up on the screen here. The index return was, let's say, 5%. The company deducted its 2% fee and that's why you are left with 3% return and what that looks like in real life. Let's say you had $100,000 invested in this particular ETF or index fund. So a 5% return would have meant after one year you would have been left with $105,000. However, at a 3% return, you are left with $103,000. So the difference here is $2,000. You would have essentially lost $2,000 that year because of the fee. Now let's see what would have happened to your portfolio if the stock market had a 0% return. So now the stock market, we can see, didn't lose any money At the end of the year. It was a return of 0%. But if your money was in an index fund or an ETF and the fee was 2%, your statement at the end of the year will show that your portfolio returned minus 2%. Why? Because, again, the company has taken the stock market return the index return, let's say 0% and then deducted their fee. And so what does that look like in real life? A $100,000 invested in the stock market would have returned. Let's say, if it was a 0% return at the end of the year you'd be left with $100,000. However, with a return of minus 2%, you would be left with $98,000. Again, the difference is $2,000 would be lost to the fee itself. On the screen here you can see the typical MER fees on average mutual funds anywhere from 1.5% to 3%. Some of them are even higher than that, but we're just looking at averages here. Index fund a little bit better 0.5% to 1.5% annual fee and ETFs a little bit better 0.03% to 1%. Again, some of the fees might be a little lower, some of them might be a little higher, but this is an annual fee, so keep that in mind if you're owning these types of investments for 5, 10, 15, 20, 30 years. Every single year you are going to be paying a fee. Now the fee is not doesn't make a huge difference in the beginning if you're investing in small amounts. So take a look at this. I mean, if you're investing a hundred dollars in an ETF, or a thousand dollars or even five thousand dollars, it's not going to seem like the fee is very big. So you can see up on the screen here five thousand dollars With an MER fee of two percent is going to cost you a hundred dollars after one year. So that's still a lot of money, but maybe for some people it's not the same. Five thousand dollars invested in a fund where the fee is one percent will cost you fifty dollars after one year. Five thousand dollars invested in a fund where the fee is zero point five percent Will only cost you twenty five dollars a year. And now let's do one last example when the fee is zero point zero five percent. So it's a very low fee. Five thousand dollars invested in there will cost you two dollars and fifty cents after one year. So, like I said, when you look at this and your investment is small and you're just looking at the cost for one year. It doesn't seem very significant, significant, right. So you might say to yourself, well, that's a small price to pay, I'll just let someone else invest for me and I'll continue to pay the fee. However, the true cost of the fees is Going to depend on four things the amount of money you invest initially. Your continued Contributions, because most people invest regularly, monthly or at least annually, towards their Retirement or savings. It's also going to depend on the rate of return and depend on time, like what is your age? Are you starting in your 20s and 30s, 30s or 40s? And how long are you going to stay invested? So let's take a look at a real-life example. So let's assume you're going to start initially with a with five hundred thousand dollars. Now I'm making a lot of assumptions here and I'm for sure in the next slide I'm going to give you a link. You can go try it yourself with your own numbers. But here this would be somebody in their 30s or 40s working professional. This is a total combined portfolio of their 401k, the IRA, if you're in Canada, your RSP, tfsa, so including your registered funds, non-registered. We put everything together, all of your investments together. So let's say you've got five hundred thousand dollars there, and so you have that option. You can invest it by yourself Into individual stocks, or you can put that money into an ETF when the company is then going to turn around and buy stocks with it anyway. So let's just start with five hundred thousand. Like I said, next slide I'm going to give you the link you can put your own numbers in and see what that looks like. Then most people will contribute regularly towards their savings or retirement. So here I'm going to take an example of a hundred dollars a month. Some people might do more, some people might do less, but in this example let's go with a hundred dollars. Rate of return I'm going to put in eight point five percent. Now, if you read any investing book, it'll tell you, over the long term, the last 70, 80 year history of the stock market here in the US and Canada, generally the rate of return average annual rate of return has been anywhere between 7, 8 percent to 11 percent. Okay, so some people use 10 percent as a number. I'm going to stick with 8.5 for now. Again, you'll have a link. You can put your own numbers in there, and then we're going to take a look at two time periods. So one is going to be investing for 25 years and the other one is going to be investing for 45 years. So even if you're in your 30s and If your health is good and you live for a very long time, you may stay invested for 45 years or more. So let's take a look at the 25 year period and 45 year period. Okay, so let's start with an MER fee of 0.5 percent. So we're going to start with a low fee here $500,000 invested after 25 years, that portfolio will be worth 3.5 million dollars. Okay, after 45 years, it'll be worth 16.5 million dollars. By the way, at the bottom of the screen there you can see the link. I highly recommend you go to that link. It's an online Mutual fund fee calculator and you can put in your own numbers in there and see what your portfolio will be worth in 5, 10, 15, 20 years and see what the fees are going to be that you are going to pay over that same time period. Okay, one more example here let's Take a look at where the fee is even less so 0.05 percent. Okay, so the same $500,000 invested in there after 25 years is going to be worth a little bit more 3.9 million dollars. After 45 years it's going to be worth even more 19.8 million dollars. So this all sounds good. You can take a look at the numbers and you say, yeah, that's good performance, I'm happy with that. Now let's take a look at how much the fees Are cutting in to that final value. So if we take a look at the first one is 0.5 percent annual fee the same $500,000 invested. After 25 years you will lose over $426,000 to fees. Now does that make any sense? Your initial investment was $500,000, your initial investment was $500,000 and you've lost over $426,000 to fees after 25 years. So I don't know about you, but I could use an extra $426,000 in my life. After 45 years the fee will exceed 3.7 million dollars. So if there was a way to save that fee, then you could pocket that 3.7 million for yourself. Let's take a look at one more example where the fee is even lower 0.05% MER the same $500,000 invested. After 25 years you will have lost over $44,000 to fees. Now, that's considerably lower than with the first example I gave you, but it's still almost $45,000 here lost to fees, and after 45 years you will have lost over $412,000 to fees. So again, if you can, it would be worthwhile to save that money for yourself rather than to lose it in those fees. Now, this is typically if you invest in individual stocks. This is what it looks like in terms of fees. So there are apps and companies out there and brokers out there that now let you trade stocks for zero cost. Some of them charge $5 per trade and some of them charge $9 per trade. So, a $500,000 portfolio you're looking at maybe $175. Or if you're going to buy more stocks or trade, you're looking at maybe $275. And that's a one-time fee. The cost to purchase, you know, 15, 20 stocks, even 30 stocks, versus paying anywhere from $44,000 to 3.7 million in fees. Okay, so now we're going to move on to our last topic and our ETFs for you, right? So we talked about the disadvantages. Are there any benefits here? So ETFs are best for people who do not have the time or the desire to select quality, dividend paying stocks when they are priced low. Now the Simply Investing Platform can help you do that. So that's certainly a huge advantage and then you can save on the fees that we just talked about. Second sort of reason ETFs are good for people who do not have the knowledge to select individual stocks. But that's where the Simply Investing course can come in handy, and that's what I designed it for Complete beginners, and it will teach you how to apply the 12 rules of Simply Investing to any stock anywhere in the world. And lastly, etfs are good for people who do not have the patience or the confidence to invest on their own, and that's the biggest reason why I started this dividend podcast. You'll see that every single episode is an educational episode and it teaches you different topics, right. How do you know what is the PE ratio? What does that mean? How do you look at the debt level for a company? What does the payout ratio mean? So this dividend podcast is designed to teach you about investing in stocks as a dividend investor. So hopefully that will build your confidence, right? So people say you know, well, it's easy, I'll just put the money in an ETF. It's very hard to select stocks because there's so many to pick from. Well, with ETFs, there's literally hundreds, if not thousands, of ETFs to choose from. So there's still some considerable work that needs to go in to picking and choosing which ETFs to invest in. So why not take that time and energy and just apply the 12 rules, and then you can save yourself the thousands and millions of dollars over your lifetime in fees. Now here's some of the questions I hear all the time. People will say well, I don't know how to invest, I'm not an expert, isn't this risky? Or I'm not good at picking stocks? You know what do I even invest in, how do I know when to buy and sell and how do I manage my investments? And these are all valid questions, and I had these myself as well before I started investing. So what's the solution here? The solution is knowledge education, right. First, you have to learn how to invest before you can invest. So I'm going to go back to my approach to investing, which is how to invest safely and reliably for the long term, regardless of what happens in the stock market. So how do we do that? We invest, like I said before, in quality dividend stocks when they are priced low. And how do you know when you're looking at a quality stock and how do you know that it's priced low? Well, for that, we showed you in the beginning of this episode the 12 rules of simply investing. So they're up on the screen now, the 12 rules. I'm not going to go through them again. We just covered them at the beginning of this episode. But for those of you that are interested in learning more, I do have a Simply Investing Online course. It's a self-paced course. It comes in 10 modules. They're video modules, so you just watch them. We start off with the investing basics. In module 2, we cover the 12 rules of Simply Investing. In module 3, I show you how to apply the 12 rules to any stock anywhere in the world. I give you a Google Sheet, which is a spreadsheet you could fill it in. It shows you, I take you step by step on how to fill it in, and then the Google Sheet will highlight which companies fail which rule. In module 4, I show you how to use the platform. Then I will show you how to place your first stock order, step by step. Then I'll show you how to build and track your portfolio. Then we look at when to sell, which is just as important as knowing when to buy. Then we look at reducing your fees and risk. We talked about fees in today's episode. Then I provide you with your action plan to get started. And module 10 is answering your most frequently asked questions. And, for anyone who's interested, we do have the Simply Investing platform. It took me a little over two years almost three years to build the platform. It is a web application that automatically applies these rules to over 6,000 companies in the US and in Canada every single day. So when you log into the platform, it'll show you which companies pass which of the rules and so that you could consider those for investment, and we show you which companies to avoid because they fail some of the 12 rules. And we'll show you the rules and so you can avoid those companies altogether. So you may want to write this down. If you're interested, there's a coupon code SAVE10SAVE10. It will save you 10% off of the course and the Simply Investing platform. If you enjoyed today's episode, please hit the subscribe button. I have a new episode out every week. Hit the like button as well and for more information, take a look at our website, simplyinvestingcom. Thanks for watching.