Index Funds vs Individual Stocks: Which is Right for You?

I may earn money or products from the companies mentioned in this post.

There will always be an ongoing debate whether index funds or individual stocks are the best way to go about investing. On one side of the argument, index funds are better, because they give you the overall performance of the market, or whatever index it's tracking. For instance one of the most popular ones, the S&P 500 index.

Those in favor say it's much better to invest in index funds because the cost is low to manage them, and you don't have to do much work to get an “average” performance. In reality, it's a better than average performance because 99% of actively managed US equity funds underperform.

The index fund is really just a collection of stocks the index is tracking and more or less matches the performance exactly, less the fees of the fund. Typically you can find fees as low as .05% or even .01% in some cases.

Those against the index fund go as far as to say passive investing is worse than Marxism. Yikes!

But the thing is, it doesn't really matter. It depends on your situation and what you're comfortable with. There isn't a right or wrong answer on what approach you take. Until there is no more room for growth in index funds, it's still a solid option.

If there was no more room for growth in index funds, this would mean 100% of assets from investors would be invested in index funds. However, apparently close to only about 20% of the combined value of all stocks are owned by index funds.

This obviously means 80% is made up of active investors trying to beat the market. There's more than enough room to invest in index funds, for the time being, so don't let anyone tell you otherwise.

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Pros of Index Funds

Minimum Amount of Work

Like I mentioned above, you hardly need to do anything when it comes to index funds because there is no research or management needed
The most you need to do is set aside a portion of your paycheck to pay yourself first on top of the 401k contribution you already have set to match at least the bare minimum of the total company matching plan if there is one
Once you set that amount aside, whatever it is, no matter how the market is doing, put it in the index fund
Because you're here reading this, basically we've implicitly agreed your time horizon is going to be 40 or so years, so no need to over think it

Maintain an above average performance while 99% of mutual funds run by money managers fail to beat the market over time

In further reference to the article I linked to in the 2nd paragraph about mutual funds, in reality, you'll be performing above average if you stick with the S&P 500 index fund
These money managers try to outperform the market over and over and over again
But the problem is, they're usually too smart for their own good, over think things, trade way too much and include those fees that really screw you over
Since 99% of mutual funds fail, just by getting an average performance of the S&P 500 makes in the top 1% of performers; Why would you need anything else?!

Less Volatile Compared to Owning Individual Stocks

Stocks can vary wildly in price throughout a year, sometimes even months
If a quarterly report of a company doesn't go well, the stock can drop tremendously depending on how bad the news is
Of course, this is from investors impulsively reacting to the day-to-day noise instead of thinking long-term, but would you be able to handle the lows?
Sometimes it's just best to get a good night's sleep and work on ways to improve your saving habits and finding ways to make more

Fees are Low

Index funds have low costs because they require very little if any management
There is also zero trading going on unless a company is replaced in the index that the fund is tracking, which doesn't happen very often; less trading means lower fees
And if it does, usually that's a good thing, for example when Apple replaced AT&T in the Dow Jones
Fewer fees for peace of mind you will match the average performance without having to do extra research sounds like a good deal to me

Cons of Index Funds

Perceived lack of downside protection

This isn't true though, because all stocks and indexes go down at some point
People can say you're stuck in one classification of an index, but that index is comprised of stocks from various industries, so it is diversified
All stocks and indexes go down at some point, and even then, all you need to do until then is frame your mind to realize that, that is the best time for you to take advantage and invest when the index is cheap
There is also a potential downside looming in the future if everyone were actually to be invested in index funds, but until then, who cares? Just don't ever invest in bonds and you're good

No control over your holdings

If you want to own a specific stock of a company and it's not in the index, then you're out of luck
Index funds are not your game if you're looking to individually hold stocks you prefer
You can't add an additional stock to the index fund from your choosing, it doesn't work that way
You either hold a piece of the total index, or you invest in stocks, you can't do both within the fund

More expensive than investing in individual stocks

If you buy stocks, there are no expense ratios attached to them
Of course, depending on how your brokerage account is set up, there may be some trading and transaction fees, but as far as expense ratios go for owning the stock each year, there are none
With index funds, you can be charged anywhere from .01% to 1% or even a little more
For mutual funds, forget it, you can get screwed over and be charged over 2% which happened to me before I began taking charge of my account, so stay away from mutual funds that aren't index funds

The dividend yield isn't as great as several stocks' yields

Right now as of this post, the dividend yield for the S&P 500 index is 1.76%
There are several stocks right now who offer better yields than what the index is giving
- For example, BP Prudhoe Bay Royalty Trust offers a dividend yield of 21.97%
- What is it? I have no idea! I just looked it up and it's a royalty trust. Just because a dividend yield is better doesn't mean it's the right thing to invest in. Don't be dumb, do your research before investing.
I've mentioned why dividend yields aren't a great way to measure a stock's worth in the past, but it is important to track the actual dollar amount of the dividend and if it's gone up over time or not
Dividends can be the secret weapon to your net worth and index funds may not offer dividends as high as some great stocks out there

Returns may not be as high as some stocks over a long period of time

Since February 2008, the S&P 500 index has increased 100.5% at the time of this writing
Amazon's stock has increased 2,122.32% within the same time period
So therein lies the opportunity cost of choosing one over the other in a nutshell
But, if you're gonna tell me you would've been able to handle the psychological warfare from owning Amazon's stock, you're either full of it or seriously delusional
Amazon's stock was at $86.40 on August 1, 2008; it went to $37.86 on November 21, 2008, a little under 4 months later, not even a third of a year gone by
That's a 56% drop ladies and gentlemen

Pros of Individual Stocks

Cheaper than mutual funds or even index funds because of the expense ratio

It's the same thing as I mentioned before, just reversed, but I want to be extra clear on these things
If you know what you're doing and can keep a cool head, stocks can be a great option, because they do not have any expense ratios charged to the stock on an annual basis
There is no fee other than buying and selling fees you may have set up in your account with your brokerage firm
If you can be calm in situations when things seem bad, invest more when that happens and have a long-term view, you will be just fine as long as you do your homework before investing in any stock

If you're diligent and do your research, you can see much greater rewards for investing in a single stock than an index fund

The S&P 500 index fund gives you more or less an average performance of 7% when counting inflation
As of November 28, 2017, if you had invested $1,000 in these stocks you would have reaped much greater rewards than simply investing in an index fund
Of course, hindsight is 20/20; would you have invested in Netflix in 2007 after going through its financials? Probably not
But the point is, there is the opportunity out there if you put the time in

You have full control over what you're buying

Mutual funds don't disclose what exactly they're invested in
Index funds do, but you don't have a say in which companies should be in it and which shouldn't be
Buying stock of companies gives you the freedom to invest in whatever companies you want
Maybe you know more than the average person and have worked in the food industry for a few years
Find patterns in the industry on the direction it's going, read the annual reports of the companies you're interested and invest if your heart desires

Companies can have stock repurchase programs

Repurchase programs is a stock re-acqusition by a company buying its own stock back
This improves the shareholder value because the earnings per share increase as there are fewer stocks available while the earnings remain the same
This also shows investors the company has a tremendous amount of cash on hand if they are pursuing a stock repurchase
By buying large amounts (usually millions) of its own stock, this shows investors they have confidence in the operations of the company for the future

It's easier to manage taxes on individual stocks

Since you're in charge of when you sell the stocks you own, you determine when you realize the capital gain on the stocks
As of now it's great to own stocks for the long-term, creating even less work for you, since the capital gains tax is 0% for those who are in the 10%-14.99% tax bracket, 15% for those who fall in the 25%-35% bracket and 20% for those who fall into the 39.6% tax bracket
Why sell when you can reap even greater benefits later and at the same time create less work on your taxes?

Cons of Individual Stocks

You have to do lots of research before you make a decision

You don't want to be reckless in building your nest egg for retirement
Lots of careful consideration and planning needs to be taken into account before you invest even one dollar
You have to be very patient when doing your research, and you cannot overreact to any clickbait you read over the internet; keep your head down, do your work, and only when you feel confident enough you've put enough work in should you invest if the company's stock appears to be at a good value
Reading material can be the annual reports, understanding how to read a balance sheet, reading up on the competitors, seeing if the business is easy to follow, etc.

It's harder to get diversification

Although Charlie Munger argues against diversification in order to get the maximum performance, depending on how you look at it, it can be a drawback; I'm currently reading Poor Charlie's Almanack and that was one of his beliefs and it does make sense
BUT, a warning of this approach is what happened to AIG's stock
- A lot of employees had their 401k money tied to the company and that was a nightmare
- From 2000-2003 the stock went from $1,737.20 to $1,040.77 and then after the financial crisis, all the way down to $5.86.
If you do want diversification, you're going to spread your money very thin and you may not get the performance you were hoping for, and it very may well be below the market average

If you're impatient, investing in individual stocks are also not a good bet for you

It can take a long time before you see your initial investment come to fruition
If minor things like corrections even scare you, don't even think about investing in individual stocks, it's not for you
Like Benjamin Graham, Warren Buffett's mentor said, in the short-term, the market is a voting machine, but in the long-term, it's a weighing machine
You have your odds against you if you have a short-term view, you never know what can happen
If you can't handle the ups and downs, stick with index funds

In most situations, the average investor should look only to own the S&P 500 index fund, because it is usually the cheapest and gives you an average performance less inflation of about 7%. You have peace of mind knowing the average will play out, and you can sleep soundly knowing you won't lose all of your money in a silly investment.

What's your opinion, do you prefer index funds or individual stocks? What research do you do beforehand?

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