Photograph: Interior of First Baptist Church in Savannah, Georgia
Is there a different approach to selecting an individual stock vs. choosing an ETF? In my mind the answer is, yes. For example, the "Creme List" is created by using approximately 20 different metrics. Stock selection usually requires some sort of fundamental analysis that includes the following: Price/Earnings, Cash Flow, Dividend Growth, Price/Book, Earnings Predictability, etc. Many small investors pay no attention to asset allocation when it comes to constructing a portfolio. It is common to hear talk that a portfolio is sufficiently diversified if 15 to 20 stocks are in the portfolio. This is a myth that needs to be excised from common thinking as it is commonly wrong. While it may be possible to build a diversified portfolio with as few as 20 stocks, it is highly unlikely.
While stock selection depends on some sort of analysis, choosing ETFs for a portfolio requires a different mindset. Instead of setting up a screen to isolate stocks with particular characteristics, ETF holders begin the portfolio construction process by first thinking broadly about portfolio makeup. Portfolios can be built around sectors, but I consider that a shortsighted approach as many parts of the market will be missed. Instead, I highly recommend asset allocation theme thinking. What assets should one include in a portfolio? After the specific asset classes have been determined, it is time to think through the process of what percentage to include in each asset class. Numerous examples are available here at ITA Wealth Management.
As an example of one portfolio building block, consider REITs. Assume I want to include REITs in the portfolio. If REITs is a viable asset class, I have a number of options to choose from, but I generally do not stray far from Vanguard or iShares for my ETFs. In this case I will either use VNQ or ICF. I generally use Vanguard ETFs if they cover the asset class of interest. In this situation I will go with VNQ although I do hold shares of ICF in some of the older portfolios.
What percentage to allocate to REITs is an even more difficult decision. I generally keep the percentage between 7% and 10%. Keep in mind this is a very personal decision. The percentage needs to fit the requirements of the investor.
Once I decide to include REITs in the portfolio and VNQ is the chosen ETF, I do not run any sort of analysis on VNQ. If I were selecting an individual REIT stock, the analysis would take a different path. I will try to select an appropriate entry point for the ETF, but if this is a new portfolio, I normally set a limit order very close to the current price and hope to hit it within a few days.
The process of building a portfolio through individual stocks selection is quite different from putting a portfolio together using index ETFs.