Is it Better to Buy Individual Stocks or an Index Fund?

Individual stock picking versus index fund investing – it’s an age-old debate that rages on.  Knowing the pros and cons is essential for investors of all stripes.

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Buy the Stock, or the Whole Market?

Before the Internet invaded people’s homes and workplaces, financial experts and individual investors alike would engage in heated debates about whether it’s better in the long run to buy stocks representing individual companies or index funds representing an entire sector or market.

Now, the debate continues unabated but presents itself in a different format:  a digital one in which social media enables folks from all walks of life to express their preferences.  But are we any closer to a sense of clarity on this issue?

Looking at it from Both Sides

Arriving at a balanced response to this debate means looking objectively at the pros and cons of both approaches to investing.  Choosing to invest in index funds, which are mutual funds or ETFs that attempt to track and replicate the performance of a sector of stocks or sometimes an entire market, certainly has its advantages.  On the other hand, individual stock pickers may tout the advantages of their methods just as emphatically and with equal conviction.

As we explore both sides of the issue, bear in mind that this exploration need not be divisive or mutually exclusive.  Indeed, it is entirely possible to incorporate both approaches, index investing and stock picking, into one’s overall investing plan.

Safety First

For me and for many investors, having a safety-first attitude is a foundational principle.  To paraphrase Warren Buffet, rule number one is “Don’t lose money,” and rule number two is “See rule number one.”

Personally, I don’t the “Don’t lose money” principle literally, but rather as a guideline that minimizing risk is a sound investing policy.  One way to minimize risk is by diversifying one’s allocations, and index funds provide a low-cost and convenient way to achieve this.

Sure, you could effectively “build your own fund” by purchasing a variety of stocks.  But then, consider the amount of research that this would involve: a careful investor would need to identify and vet a wide variety of companies for possible inclusion in his or her portfolio.  Then you’d have to factor in the commissions and fees involved in purchasing (and, most likely, eventually selling) many stocks.

… or is it Convenience First?

Beyond the advantages associated with reduced commissions and fees (assuming you’ve shopped around for a relatively low-fee, low-expense-ratio fund), it certainly is easier to just buy an index fund than to shop around for a variety of individual stocks.  Plus, there’s the safety factor of instant diversification when you’re participating in an entire sector or market as opposed to an individual company.

Nonetheless, it should be noted that index fund investing isn’t entirely effortless, as a successful ETF or mutual fund investor still needs to know what he or she owns.  This means doing your due diligence on the industry, market, or sector that you’re investing in; as with most other endeavors in life, knowledge is power.

Besides, identifying and researching individual companies doesn’t have to be inconvenient.  In this day and age, there are apps and websites available to assist investors in their search for solid stocks that can provide steady, lower-volatility returns over time.

Greater Risk, Greater Reward

While I wouldn’t claim that the correlation between risk and reward is absolute, it has been my experience that reduced volatility typically means a subdued profit potential as well as an often reduced exposure to extreme losses.  In other words, buying individual stocks will frequently expose the owner to bigger swings in price action, both to the upside and to the downside.

For instance, we might witness a company having a disappointing earnings report, or the CEO might get embroiled in a scandal.  In that case, the stock’s shares might go down 5%, 10%, or even 20% or more in a single trading day.  Ouch!

Whether it’s tracking the S&P 500, the Dow, the NASDAQ, or a market sector, you’re not likely to see a popular index fund go down 20% or more in a single day.  But then, let’s not assume that’s impossible; most seasoned investors recall the day in 1987 when the Dow Jones Industrial Average plummeted by 22.6% in one day.

It’s up to You

There really is no “winner” or “loser” in the stock picking versus index fund investing debate.  It’s all a matter of one’s individual financial needs, objectives, and risk tolerance – factors that should guide any long-term investing plan.

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