Can ETFs And Stocks Coexist In A Portfolio?

Can ETFs and stocks coexist in a portfolio and make that portfolio better? ETF or index ETF investing versus do-it-yourself dividend growth investing is always a big debate. You know I favor stock investing, but I keep an open mind. There is room for ETFs even if you invest in stocks.

I see both ETF investing and dividend growth stock investing strategies work very well. Should you put both in your portfolio? It depends. Let’s elaborate.

So yes, I see situations in which combining individual stocks with an ETF, or several ETFs makes a lot of sense.

Adding different asset types to your portfolio

Combining ETFs with some dividend growth stocks works well if you want to have several types of assets, exposure to several markets, and not have to spend too much time building that up and monitoring it.

You could start with an all-in-one ETF that has exposure to fixed income, maybe to some basic materials stocks, international markets, and the U.S. market. Use this to build your core portfolio without too much effort. Perhaps 50% of your portfolio is that ETF or split between two ETFs that don’t overlap. Your ETF is rebalanced automatically and gives you exposure to the markets and other types of assets like bonds or preferred shares that you want.

Then you add a few stocks that you like that you want to follow regularly, maybe a dozen stocks to complete the portfolio. This could work very well because you are well-diversified; a very smart way to build a portfolio.

It’s like cooking; you have your basic recipe and then add a few spices on the side, your special ingredients that make the soup even better. Start with an ETF that holds many ingredients and add a few dividend growth stocks as special ingredients.

Adding exposure to specific markets or sectors

It’s also logical to combine ETFs and stocks in the opposite situation, one in which you have a well-diversified portfolio of stocks – perhaps about 30 stocks – but you want exposure to a specific market or a specific sector.

You could use ETFs to invest in emerging markets for maybe 5 or 10% of your portfolio. Investing in emerging dividend growth stocks can be quite difficult. Adding an ETF tracking emerging markets does the job.

You could also add an ETF to get exposure to a sector or industry, artificial intelligence for stocks, or the whole information technology sector for example. If you don’t know how to choose individual stocks in this sector, or you’re concerned about their current high valuation and P/E ratios, adding an ETF can work well. It completes your portfolio adding more diversification without having to spend a lot of time and energy trying to understand a sector you’re not comfortable with. See our post about sectors and industries to learn more.

Remember investing has a lot to do with having confidence in your strategy to not worry when the market goes down. The best way to have confidence is to make sure that you understand what you own and why you own it

Two ways to make ETF and stocks work well together in your portfolio are having a core ETF portfolio and adding some stocks you like and want to monitor, or having a portfolio of stocks and selecting specific assets or specific sectors you want to have exposure to and go with ETF.

However, there are scenarios where combining stocks and ETFs in your portfolio is a bad thing.

Beware of duplication

A common investing mistake is having an overlap between ETFs and the stocks in a portfolio. For example, you invest in an ETF tracking the Canadian market. Then you add Canadian stocks for banks, pipelines, telcos, and utilities. A lot of these stocks are included in your ETF, so you’re just adding more of the same.

The problem with that is that you don’t know your complete exposure to each individual stock that you own because you also have some through the ETF. You could end up with 10% of your portfolio in TD Bank without even knowing it or wanting it. Combining an index ETF with individual stocks in the same market requires a bit more work to avoid overlap between them; look at the top ten or 20 holdings of ETF you have, to ensure you don’t buy those individual stocks.

Just like cooking: adding coarse salt, sea salt, and Himalayan salt won’t make your dish better, just saltier. Add too much, and it’s inedible.

Don’t over-diversify

More and more often becomes…too much! The second mistake is going on a shopping frenzy. Let’s say you bought a bunch of ETFs because you love to go from one idea to another or because they all just look so good! Then, you add stocks over and over again. You’ll end up with too many holdings in your portfolio.

Having 40 stocks plus 10 ETFs doesn’t make your portfolio better. You lose yourself in your diversification and strategy because you have so many different things. Several of your holdings, especially stocks, will be less than 2% of your portfolio; they don’t add much value to your portfolio returns; if they double in price, you won’t even notice.

Combining a bunch of ETFs with a bunch of stocks is over-diversification or “diworsification”, making your portfolio worse. You’ll spend so much time and energy monitoring everything in your portfolio without necessarily getting any added value. You might suffer from paralysis by analysis as too much information to track and analyze leads to doubt. Most importantly, key information can fall through the cracks. As an investor you’re responsible for your portfolio, you must know what’s going on. Losing track is bad.

The takeaway

ETFs and stocks coexisting living together in a portfolio is a good idea if you’re able to build a core portfolio of ETFs and add some stocks that aren’t duplicates. Buying ETFs also works to add exposure to specific asset types, sectors, or markets you aren’t exposed.

Having duplicate holdings is a problem, as is over-diversification. Having 60 lines in your statements is not good. It leads to doubt, paralysis by analysis, and loss of control over your investments.

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