Thursday, August 24, 2006

Switching from stocks to ETFs

I created my ROTH IRA in 2004, and for the last 2 years I've been investing in individual stocks. I lost a lot of money at first because I had no idea what I was doing. One of my first stocks was a "hot tip" from a friend, and it turns out that I bought the stock at its absolute peak value. Fortunately I got out with only a 5% loss; in the meantime the stock has gone down 90% ... whew!

In the interest of diversifying, I started buying different stock positions of $500 apiece. To get some ideas on which stocks to buy, I subscribed to two different newsletters from the Motley Fool. I started with Hidden Gems in 2004, then switched to the Stock Advisor in 2005.

The Hidden Gems newsletter was overwhelming, because it gave no fewer than 7 small-cap stock tips each month. I was only allowed to invest $3,000 in 2004 and $4,000 in 2005 (ROTH IRA rules), so I couldn't take full advantage of the monthly advice. On top of that, as a "bonus" I received 12 more unrelated stock tips from the Motley Fool in 2004 and 2005, giving me even more choices and more headaches.

By the middle of last year, I managed to turn my original $7,000 into $5,500.

Since I started using the Stock Advisor, it's been easier to keep up with only 2 stock picks per month.

Alas, my portfolio hasn't gone anywhere in the past year. I've added another $4,000 to my ROTH this year, and it's now valued at $9,500, so I'm still down $1,500.

Now, any experienced investor would advise me to be patient and not to judge these stocks based only on a one-year track record. But when I noticed that my lowly TIAA-CREF retirement account was outperforming my ROTH, I couldn't take it any more. This isn't supposed to happen! I've only got a limited number of mutual funds to choose from with TIAA-CREF, so it's not easy to substantially outperform the market there. On the other hand, the Motley Fool stock picks have gone up an aggregate of 55% since the Stock Advisor started picking stocks in April 2002. That coresponds to an average annual gain of 22% per year. So why haven't my Motley Fool stocks been doing this well lately?

Well, here's one catch: most of the Stock Advisor picks are mid-cap stocks, and mid-caps as a group have gone up 82% since March 2003, or 18% annually. So over the past 3 years the Motley Fools have been beating "the market" by only about 4% per year. (Note that mid-cap value stocks have risen 100%, or 22% annually!) Mid-caps also fell hard in May, and they are now basically unchanged from a year ago. That probably explains why my stock portfolio has been sitting in neutral.

What's more, I had actually invested in two mid-cap funds in my TIAA-CREF account. In early May I noticed they were slowing down, and I dropped them before the big losses happened. So why should I be stuck with 2 new mid-cap stocks per month from the Motley Fool when mid-caps as a whole are now lagging behind the S&P 500? If I use exchange traded funds (ETFs) to jump in and out of different stock sectors at the right time, I should be able to do as well as the Motley Fools without having to keep track of dozens of stocks.

There are several ETFs that have outperformed the S&P 500 over the past few years. Since March 2003, for instance, Large-cap value stocks (IVE) are up 80%, Real Estate Stocks (IYR) are up 80%, European Stocks (IEV) are up more than 100%, and emerging markets (EEM) are up 170%.

Most importantly, it looks like past performance can be used to judge future performance. In only the past year, IVE is up 10%, IYR is up 13%, IEV is up 24%, and EEM is up 26%. All of these funds were already outperforming the S&P last year, and all have further surpassed the S&P's gain of 5% since then. If I had invested equally in these four funds last August, I would now be up 18%, nearly recovering all of my earlier losses.

So I'm going to make the switch to ETF's. In future posts I will discuss the selling of my remaining stocks, picking ETFs that I think will perform the best, and deciding when to add money to my ETFs.