If you are new to investing, you probably have high expectations of how much money you can make investing in the stock market. Right to the heart of the matter goes the question of Individual Stocks Vs. Index Funds: Which Is Better?
Let me start off by telling you that there is no definitive answer to this question. Your answer depends on your own beliefs, risk tolerance, strategy, and energy. It also depends on what type of investor you want to be.
Individual investors can generate good returns and grow their net worth with both, Individual Stocks and Index Funds.
Being successful with individual stocks is much harder, though. It depends much more on your ability to make the right stock picks.
Consider this 2022 case study from Vanguard: The case for low-cost index fund investing. In this study, Vanguard talks about why low-cost Index Fund Investing will continue to be a successful strategy for the long term.
In this article, I will give you all the necessary details that allow you to find your own answer.
You can generate good returns with both individual stocks and index funds, depending on your risk tolerance and strategy.
Reasons to invest in individual stocks include doing your own research, aiming to “beat the market,” supporting a specific company, and having industry knowledge.
Index funds offer instant diversification, require less time and expertise, and reduce stress for investors who prefer a hands-off approach.
Consider a combination of index fund investments and individual stocks to diversify your portfolio and meet your financial goals.
I wrote this article from the perspective of a long-term investor. I want to ensure that my readers get information that is based on my investment philosophy when it comes to stock investment:
#1 Buy and hold Stocks for 5+ years #2 Have at least 25 Stocks #3 Don’t overreact on short-term news #4 Reinvest into your winners
Reasons To Invest In Individual Stocks
There are many reasons to make the investment decision to invest in individual stocks for the long run.
However, investing in individual stocks is complex and requires a lot of research. That is why only a small portion of investors use it as their main investment strategy.
If you belong to this group and manage your own portfolio of stocks, you have the potential to generate outsized returns compared to the overall market. But you also expose yourself to much higher risk.
#1 You Like Doing Your Own Research
If you belong to a small group of investors who like to dive deeply into financial documents, investing in individual stocks might be for you.
It is not an easy job to pick individual stocks that will return better results than index funds over a long period. You will have to conduct thorough research to correctly gauge your risk. This includes reading income statements, balance sheets, and cash flow statements among many other things.
Even the biggest amount of research will never erase your risk entirely, but it is a wonderful foundation if you want to own stock of individual companies.
Of course, more research is needed to make sure that the company is otherwise in good shape. However, testing the products of a company firsthand is an excellent way to experience a brand or service. It can absolutely be part of a good investment thesis. That’s why it is part of my framework and covered in my article “How to Research Stocks: 8 Steps for Beginner Investors.”
#4 You Have Specific Industry Knowledge
If you have specific industry knowledge, you know a lot more than the average investor about some companies. You might be much more comfortable selecting good companies within that industry than in other industries.
This can be a reason to seek direct exposure to some select companies you like.
For other industries, you can still invest using an Index Fund or Exchange-Traded Funds. This allows you to use a hybrid approach.
#5 Your Stock Is Not Part Of An Index
If you are looking to get exposure to a specific company, but that company is not part of an index you would invest in, you can invest in it directly and buy some shares of stock.
Not every stock listed on the US stock market is part of an index, thus investing in it directly is a way to get that exposure.
#6 You Want To Save The Expense Ratio Of An Index Fund
Index Funds often come with an annual fee called Expense Ratio. For example, an Index Fund expense ratio of 1.5% on $10,000 invested for one year would cost you $150.
If you want to save that money, you can instead invest in your own basket of stocks, diversify well, and still get good growth. Technically you could invest in all companies that your index invests in, but that could mean a lot of manual work.
#7 You Want To Reinvest Dividends
Many brokerage services like Robinhood allow you to reinvest your dividends back into the company’s stock. When you invest in an individual stock that also pays a dividend, you can easily set that up in your brokerage account.
The vast majority of investors fall into this group. If you do not feel confident you can make the right stock picks, or if you just don’t want to invest much time, index funds are your way of investing (or ETFs or Mutual Funds for that matter).
#1 To Get Instant Diversification
Investing in index funds gives you instant broad exposure to many industries, sectors, geographies, etc. It is a great way to get a diversified investment portfolio basis.
You will not have to worry about specific company events dragging your portfolio down.
#2 You Want To Invest, But Not Spent Much Time
Investing is a great way to manage your money. By investing in index funds, you will not have to put in the time to do much research on individual companies. Checking your investments only a few times a year is probably enough.
Index Fund investing is a very hands-off approach to investing that has been proven to work for many.
#3 You Are Not Familiar With Picking Stocks
Let’s face it, picking the right stocks is hard! If it weren’t, a lot more people would do it successfully. It also requires you to have a deep understanding of company financials, the management team, growth strategies, culture, and more.
Diving so deeply into a company and being passionate about that is not for everyone. Index Fund investing removes all that heavy baggage from your shoulders and still allows you to invest your money in the market.
#4 You Can’t Handle The Stress
Having your money invested can be a stressful experience for some. Knowing that your money can potentially be lost the next day is not for everyone.
Investing in Index Funds mitigates this risk as opposed to having your money be tied to a few companies only. A problem in a single company will never bring your portfolio down, so it is a much lower risk.
Popular S&P 500 Index Fund Options
S&P 500 Index Funds are passively managed and aim to track the performance of the S&P 500 – the 500 largest companies publicly traded.
These funds are ideal for you if you aim to get returns in line with what the overall market generates.
All of these Index Funds are generating returns very close to the S&P 500, as you would expect. They have some differences like minimum investments, expense ratios, etc. But in general, they are aiming for the same thing and are very low-cost index funds.
If you want to invest in them, make sure to do your research and talk to a financial advisor before you invest any money.
Final Thoughts – Individual Stocks Vs. Index Funds: Which Is Better?
As you can see, there are many reasons for investing in both, individual stocks and index funds. You are also not required to choose one or the other. A combination of index fund investment and individual stocks is fine too.
Passive index funds are one of the easiest low cost financial products to invest your money with as little time as needed. They are the perfect solution for everyone who just wants to get invested but doesn’t have much knowledge about it. You get a broad mix of different companies, sectors, and industries.
If you choose to invest in individual stocks, you should be aware of the time required to research and follow your investment, though. Staying on top of your investments isn’t an optional step when pursuing this strategy.
Disclaimer: The information in this blog post should not be considered financial advice or investment advice. They are solely provided for informational purposes. Please consult with a financial advisor for any specific questions on your personal finances and financial goals. Also, none of the mentioned stocks are to be understood as recommendations. Don’t buy yourself something solely based on what you read here.