3 Reasons You Should Own Individual Stocks Over ETFs

If you've ever stumbled into financial TikTok, you've likely come across all sorts of unsubstantiated investment advice (among the occasional informative video). These videos are usually conveniently preluded with "this is not financial advice" right before they give you some terrible investment advice.

Troves of influencers make the claim that there's no point investing in individual stocks when you can simply buy low-cost, exchange-traded funds (ETFs). While ETFs are certainly useful investment vehicles, I don't think they are compelling enough to abandon investing directly in stocks.

Here's three things the influencers won't tell you about investing in ETFs:

Image source: Getty Images.

ETFs are heavily indexed to a small number of companies

My main issue with ETFs is that most are market-weighted. This means the fund's holdings are weighted by each stock's market cap (the share price times the outstanding share count), so that the larger companies end up dominating the overall allocation.

Consider some of the top ETFs and their overall exposure to the five largest companies in the U.S -- Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), and Tesla (NASDAQ:TSLA).

DATA SOURCE: INDEX FUND REPORTS. TABLE BY AUTHOR.

There are obviously other more specific funds you could invest in, such as energy or industrial sector ETFs that do not have exposure to these behemoths. But many investors think that by simply buying a basket of ETFs, they are diversifying. In reality, some or all of these funds will be heavily weighted to the same 5-10 companies.

In 2021, Citywire reported that the largest constituents in the S&P 500 have accounted for over 40% of the total return for the index over a five-year period.

The data indicated that about 1% of the stocks in most S&P 500 ETFs are driving the lion's share of the overall returns.

Don't get me wrong: I'm a fan of many of the big tech names, but I'd rather own them directly.

With broad-market ETFs, you're essentially buying the 5-10 largest companies on the market, but only getting a fraction of the potential upside.

Total Return Level data by YCharts

There are failing companies in the S&P 500

According to forecasts by consulting firm, Innosight, nearly 50% of the companies currently in the S&P 500 will be replaced over the next decade.

Companies get replaced in the S&P 500 when their stock prices fall enough to no longer be representative of the 500 largest U.S. companies by market cap. This means that nearly half of the stocks in the index today are likely future losers, and some of them are potentially headed for bankruptcy.

In fact, the Innosight report found that several energy and brick-and-mortar retail companies that have recently fallen out of the S&P 500 have done exactly that.

Obviously, you won't "own" these failing companies for long because they will be removed from the index, but if you believe in investing in a better future, you might not like the idea of allocating money to companies that are entering the final chapter of their corporate existence.

The diversification offered by S&P 500 ETFs (if even its heavily weighted to FAANG) can be comforting, but once you look under the hood, you realize you're buying a lot of losing companies.

Owning stocks makes you smarter

If I had a dollar for every financial influencer that has touted the advantages of buying low-cost S&P 500 index funds and ETFs over individual stocks, I'd be a much richer person.

The reasoning behind these claims is usually because you can "set it and forget it." There's no listening to earnings calls or keeping up with company filings. No research needed, just buy it and wait.

And for those that genuinely have zero interest in investment research, that is likely a smart move. After all, buying ETFs is certainly better than not investing at all.

But, one very important thing you'll miss out on when buying only ETFs is learning how businesses work. By foregoing the research process, you're also foregoing the opportunity to get smarter along the way.

Investing directly in stocks is certainly more work, and there's no guarantee that you'll beat the market. But it forces you to learn how companies make money, and over time you'll start to recognize patterns that separate great businesses from the average ones.

And in doing so, you'll become an exponentially better investor. Those that invest exclusively in ETFs do not experience this intellectual compounding effect because they are not diving into the details of the underlying businesses.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Mark Blank has positions in Tesla. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Microsoft, Tesla, and Vanguard S&P 500 ETF. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.