Index funds and individual stocks each have advantages and disadvantages.
So, how do you know which one is right for you?
In recent years, the investing app Robinhood launched with a commission-free trading model. It was only a matter of time before other online brokerage firms started offering commission-free single stock and index funds trading as well. Before Robinhood, investors could expect to spend anywhere between $5 to $10 per trade.
As a result of commission-free trading, investing in the stock market can be more attractive today. While many people are interested in building a solid portfolio that can stand the test of time, some are afraid to get in the market especially given the volatility it has had recently.
Why Invest in the Stock Market?
According to global investment bank Goldman Sachs, over the past 140 years, U.S. stocks have averaged a 10-year return of 9.2%. When you consider a 3.22% average inflation, the addition to the general increase in prices of goods and services, then the real expected stock market return is still pretty high at around 6%.
Investing in the stock market can be a great way to build wealth. But with the amount of information out there regarding investing, deciding which investment strategy to adopt can be overwhelming.
If you are looking to start investing or take a more proactive approach when it comes to your investments, here are a few things to consider before leaping into the stock market.
What is an Individual Stock?
An individual stock is a small ownership stake in a public company. Ownership stake often comes with voting rights, though it is not always the case depending on the type of stocks you own.
There are two main types of company stocks you can purchase.
- Common stock, which usually includes voting rights
- Preferred stock, which includes preferential treatment in terms of dividends and price volatility, but typically does not provide voting rights.
In theory, a stock price is mainly influenced by the company's performance, the industry, and the overall economy.
What are the Pros and Cons of Individual Stocks?
Pros of Individual Stocks
Investing in individual stocks usually means lower fees. Today, with the opportunity to trade without commissions, you can acquire stock without incurring any fees. Also, there is no expense associated with holding the stock.
With individual stocks, you make all of the decisions regarding your portfolio. You are more in control of what you invest in because you can select every company in your portfolio.
Opportunity for higher returns
With individual stocks, there is the potential for higher returns. You do not select a basket of companies; you bet on individual companies hoping to pick the next fast-growing company like Amazon, Apple or Facebook.
Cons of Individual Stocks
More risk involved
When you buy single stocks, you take a bigger risk than if you buy index funds.
Investing in individual stocks is essentially picking which companies will be the future winners.
GE's average stock price was around $51. The stock price progressively declined and traded at $26 in 2014. If you had bet on GE in 2014, then today your shares would be worth more than 50% less as GE currently trades around $11.
Can the company recover? Sure, but you would have missed out on years of returns that an investment fund could have provided by instead tracking the market.
More expensive to diversify
To diversify your portfolio by picking individual stocks, you would need to have a 20-30 stocks portfolio and ensure exposure to different companies and industries. Purchasing 20-30 different stocks can be expensive. You can get the same diversification by buying just one share of a total stock market index fund like Vanguard's VTI or Fidelity's FSKAX.
You also have the option to invest in sector-specific index funds. In 2004, Vanguard's Technology Index Admiral Fund (VITAX) traded for around $50. Recently its price has exceeded $180.
Investing in individual stocks for success means researching the respective companies, taking the time to look at their financial reports and press releases. It also involves staying informed on the industry and keeping up with potential changes that could impact the company.
Related Article and Video: How We Became Millionaires in 10 Years
What is an Index Fund?
An index fund is an investment fund holding a portfolio of stocks or bonds – debt securities issued by Governments and corporations to raise money-, that mirror a market index.
For instance, a total market index fund like Vanguard’s VTSMX represents the entire U.S. stock market and holds about 3,600 individual stocks. The S&P 500 is a stock market index measuring the 500 largest U.S. publicly traded companies' performance. A Standard & Poor 500 (S&P 500) index fund like Charles Schwab’s SWPPX or Vanguard’s VFIAX follows the performance of the S&P 500.
There are other categories of index funds, including sector-specific, which focuses on specific areas of the economy, or target-date, which adjusts the investments or asset allocation based on a set date.
What are the Pros and Cons of Index Funds?
Pros of Index Funds
Index funds consist of a portfolio of individual stocks (or bonds). When you're thinking about the “index funds vs. individual stocks debate”, know that index funds automatically provide more diversification.
It would take a lot more effort, time, and possibly money to diversify a portfolio of individual stocks. Because of the instant diversification, index funds are less risky than individual stocks.
If you invest in a handful of stocks and they all dropped in value, you run the risk of losing your investment. But, if you opt instead for a total market index fund, the impact of those stocks losing value would be insignificant because they represent a small portion of the total index.
Easy to start investing
Index funds are an excellent way for beginners to start investing. With index funds, far less research is necessary. Once you have done the upfront research to determine which fund to invest in, you do not have to keep up with the company's financial reports or press releases as you would with individual stocks.
Unlike with a single stock, any good or bad news related to one company is unlikely to significantly affect the fund’s price.
It makes it easy to invest following the dollar-cost average method. With dollar-cost averaging, you systematically invest similar amounts of money over a long period, price not being a factor.
No emotions involved
Most people who invest in individual stocks are tempted to check how their investment is doing. Depending on how the stock is doing that day, it can lead to all sorts of emotions. Emotions can lead to hasty decisions, whether you sell too low or buy too high.
With index fund investing, the index price has no impact on your strategy. When prices are low, you end up with more shares; when prices are high, you get fewer shares.
Over time, it will even out. As such, you are not preoccupied with price fluctuations and can invest without emotion.
Time and Tax Saving
Index fund investing frees up hours that you would otherwise spend analyzing stocks and tracking the market. You can reallocate that time to other areas of your life that can give you more joy.
Individual stock investors typically buy or sell based on price; for this reason, they are more likely to make more frequent trades. However, each transaction resulting in a profit, completed outside of a tax-advantaged account, will result in taxes.
Depending on whether the investment was short-term (less than a year) or long-term (1+ year), the tax rate can be as high as the investor's normal income tax bracket.
Related Interview: JL Collins – How to Achieve Financial Independence with Index Funds
Cons of Index Funds
Lack of control
When buying an index fund, you cannot decide which stocks (or bonds) to add to the fund. If you are interested in a specific company, it might not be part of your index fund. You may also dislike some of the companies that are part of the index's portfolio. Unfortunately, you do not have any control over that.
There are annual fees known as expense ratios associated with owning index funds. It is important to pay attention to expense ratios when investing.
If you opted for a mutual fund, a professionally managed investment fund, an expense ratio of 1% or more would cost you a significant portion of your portfolio over time.
As a rule of thumb, while having an expense ratio no higher than 1% is wise for actively managed mutual funds, the expense ratio for index funds that are passively managed should preferably be less than 0.5%.
As you do your research, you will see that there are many options of solid index funds (like the ones mentioned earlier in this article) with expense ratios below 0.1%. In this respect, the holding fees for index funds do not have to be significant.
The Importance of Asset Allocation
What is Asset Allocation?
Asset allocation is a strategy to balance risk and reward whether you invest in index funds or individual stocks. It allows you to adapt your investment portfolio based on your risk tolerance, age, and goals.
Each asset, whether it is cash, bonds, stocks has different risk levels and returns. As such, based on your asset allocation, your portfolio is divided among the various asset categories.
There are different types of asset allocation, but a common guideline used to determine asset allocation is age-based asset allocation.
What is Asset Allocation by Age?
Previously, the rule of thumb was to subtract your age from 100 to determine your portfolio's percentage that you should hold in equities, which are stocks or index funds.
For instance, according to this rule of thumb, if you are 35, you should have 65% of your portfolio in equities and the rest in less volatile securities such as fixed-income investments, money market funds, certificates of deposit.
However, with the extended life expectancy, the rule of thumb is now somewhere around 110. Under the 110 rule, a 35-year-old should have 75% of their portfolio in equities.
As you age, your portfolio should be less risky so you can be protected when a market downturn occurs.
You should rebalance your portfolio at least once a year to ensure that your stock portfolio size decreases over time. Also, it is important to rebalance your portfolio to make sure that it matches your risk tolerance.
Related Article: How to Invest on your Own Without a Financial Advisor
Final Thoughts on Index Funds vs. Individual Stocks
Index funds investing provides a simple path to building wealth. They are a great option as you start investing on your own.
If you are still debating between index funds vs. individual stocks, history has shown that most people who pick individual stocks cannot beat the market in the long run.
What is your view on index funds vs. individual stocks? How do you prefer to invest?
Please let us know in the comments below.