William O’Neil Said This Decades Ago.
One of my favorite distinctions from William O’Neil in Market Wizards:
“So you treat a fund very differently from an individual stock account?” “Very, very differently. With an individual stock, you absolutely have to have a stop-loss point, because you never know how far down the stock is going.” - William O’Neil, Market Wizards
This is an important difference.
An individual stock and a diversified fund should not always be managed the same way.
An individual company can permanently deteriorate.
Earnings can collapse. Management can fail. A competitive advantage can disappear. In extreme cases, the stock can eventually become nearly worthless.
That is why O’Neil was so aggressive about cutting losses in individual stocks.
But a broadly diversified fund is different.
O’Neil went on to say:
“When you buy a fund, you want to be in it for 15 years or more. That is how you will make the really big money. But in order to do that, you need the courage to sit through three, four, or five bear markets. The typical diversified growth stock fund will go up 75 to 100 percent in a bull market, but it will decline by only 20 to 30 percent in a bear market.”
- William O’Neil, Market Wizards
That gets to the heart of his argument.
A diversified fund owns many companies across the economy. Individual companies can fail while the fund survives, changes its holdings, and participates when the broader market eventually recovers.
And I think this principle translates directly to many ETFs today.
A broad-market ETF tracking something like the Nasdaq-100 (QQQ), S&P 500 (SPY) or total U.S. stock market (VTI) is much closer to the diversified mutual funds O’Neil was describing than it is to owning one individual company.
But….
Not every ETF should be treated this way.
Leveraged ETFs, inverse ETFs, single-stock ETFs, highly concentrated sector ETFs, and narrow thematic ETFs can carry very different risks.
And if you are trading an ETF tactically rather than holding it as a long-term diversified investment, a predefined stop should be used.
Don’t treat a broken individual stock like a diversified index fund.
And don’t treat a normal bear-market drawdown in a broadly diversified long-term fund like one company whose thesis has completely failed.
Ironically, O’Neil pointed out that many investors do the exact opposite.
They hold individual-stock losers hoping they come back, then panic and sell diversified funds during bear markets.
Individual stocks require protection from permanent loss.
Broad diversified funds require the patience to survive normal market cycles.
Two different vehicles.
Two different jobs.
Two different timeframes.
Two different approaches to risk.