Should you pick your own stocks or buy index funds? The debate between the two rages on, but you do not need to choose a side.
It comes down to your personal preference and financial situation. Typically those with less experience should opt for index funds since there is less risk. Picking individual stocks requires more research and knowledge of financial markets.
Investing in a mix of both individual stocks and index funds may be best. This way you’ll get the best of both worlds.
What are the key differences and outcomes one can expect between the two? Let’s go over the pros and cons of picking individual stocks and buying index funds.
What Are Index Funds?
An index fund is a type of mutual fund. It’s constructed to track a market index like the Dow Jones Industrial Average or the S&P 500.
Index funds make up the majority of core portfolio holdings in retirement accounts. They follow the overall market and have low operating expenses.
Pros of Index Funds
- Index funds are less likely to have large price swings.
- Individual stocks can have significantly large drops that are hard to stomach.
- Unless you’re an expert at picking stocks, you’ll lower your risk by purchasing index funds.
- Buying index funds is easier than picking individual stocks.
- Index funds are a simple form of passive investing.
- All you’ll need to do is contribute to the fund regardless of how the market is doing.
- There is very little management of index funds, thus they have low fees.
- Less research and low costs while matching the average market performance.
Easier to Diversify
- Index funds are made up of a large basket of stocks.
- When you invest in index funds you are investing in hundreds or even thousands of different companies.
Cons of Index Funds
- With index funds, you do not get to choose any specific stock that it holds.
- You’ll have less control over what companies you’re investing in.
Returns Are Limited
- You are not going to get oversized returns with index funds.
- If the market performs well, you’ll make modest gains. If the market flops, you’ll follow it down as well.
- The lower risk comes with lower returns including gains from dividends.
Fees Are Still Higher Than Buying Stocks
- While the costs of owning index funds are low, they are still higher than purchasing stocks.
When you purchase a stock, you become a part-owner of the company. If the company does well, you’ll likely make a nice return. If the company fails, you can lose all of your investment.
Pros of Buying Individual Stocks
Cheaper Than Index and Mutual Funds
- There are no operating costs for owning stocks. While index funds have relatively low expense ratios, stocks have none.
Possibility of Oversized Returns
- There is essentially no chance of beating the market with index funds.
- If you do your research and pick the right stocks, you can outperform the market.
- You can get handsomely rewarded for taking on the risk of buying individual stocks.
Complete Control Over What You’re Buying
- Picking stocks means you get to pick the exact companies you want to invest in.
- If you are particularly bullish on a stock you can allocate more of your funds into it.
You’re Likely To Learn More
- Purchasing individual stocks makes you think more about what you’re investing in.
- You’ll have to do additional research and you’ll have to take on higher risk.
- It’s more active than buying index funds and you’ll get to learn more about investing.
Cons of Buying Individual Stocks
Extra Work is Required
- You’ll need to take more time researching companies and even perform some technical & fundamental analysis.
- For a beginner investor, it can be a daunting task that will take up a lot of time.
- Both stocks and index funds involve risk but there is a
greaterrisk when buying individual stocks.
- If a company has a bad earnings report or other poor news, it’s share price can drop tremendously.
- Even the most experienced and knowledgeable investors can choose poor performing stocks.
Harder to Diversify
- It’ll take additional work to build a fully diversified portfolio with stocks instead of index funds.
- You’ll need a larger amount of capital to diversify with individual stocks.
You’ll Need to Have Thick Skin and Patience
- Your stock picks could end up performing poorly at first, yet outperform later on.
- You’ll need to be patient and not act on emotions.
- If 20-40% corrections in share price cause you to panic, you’re better off sticking with index funds.
Index funds and individual stocks both have very important roles.
In most cases, the average investor is better off buying index funds or ETFs that follow the market. Dollar-cost averaging into index funds is an easy and passive way to invest.
Pick stocks if you enjoy researching companies, finding patterns, and closely following the market. Pick index funds if you don’t have time to do your homework.
Putting the majority of your investment money into low-risk index funds and the rest into individual stocks is a common strategy as well.