One of the most important decisions that investors need to make is whether to invest in individual stocks or in index funds. While both give you exposure to the market, they do so in different ways and have different advantages.
In this guide, we’ll explain the pros and cons of individual stocks vs. index funds to help you decide which is better for your portfolio. Ready? Let’s get started!
- Individual Stocks vs. Index Funds: What is a Stock?
- Individual Stocks vs. Index Funds: What is an Index Fund?
- Individual Stocks: Pros and Cons
- Index Funds: Pros and Cons
- Examples of Individual Stocks vs. Index Funds
- Individual Stocks vs. Index Funds: Which is Better for Investors?
- Conclusion: Individual Stocks vs. Index Funds
Individual Stocks vs. Index Funds: What is a Stock?
An individual stock is a share of a company. It represents ownership in the company and entitles you to dividends and voting rights. From an investment perspective, a stock can gain and lose value over time as the perceived value of the company it represents goes up or down.
Individual Stocks vs. Index Funds: What is an Index Fund?
An index fund is a type of mutual fund or ETF that serves as a basket of multiple stocks. They are typically designed to track the performance of major market indices like the S&P 500 or the NASDAQ, although there are also index funds for individual market sectors or foreign countries.
The value of an index fund goes up and down as the values of the stocks it tracks rise and fall. However, since there are many stocks inside an index fund, the change in a fund’s value on any given day is a weighted average of the change in all the constituent stocks. So, if half the stocks in an index fund gain 1% and the other half lose 1%, the value of the index won’t change at all.
Individual Stocks: Pros and Cons
Potentially higher returns: The main reason that many investors choose to invest in individual stocks is that this style of investing offers potentially market-beating returns. If you pick a hot company or get into a stock at the right time, you could see double-digit gains in just days or weeks.
More specific investments: Picking individual stocks also lets you precisely control what companies and sectors you’re invested in. You get to decide what company is the best investment in each market sector, for example, or whether you want to invest in a specific emerging technology.
Increased control: On top of controlling what you invest in, you also get to control how much you invest in any one stock and when you buy and sell. These decisions will impact the overall balance of your portfolio and the taxes you’ll pay on your investments.
No management fees: While you might have to pay a commission to invest in individual stocks, there are no ongoing management fees to worry about.
Potentially lower returns: Just as investing in individual stocks offers the possibility of beating the market, it also offers the possibility of underperforming the market. If you’re not good at picking stocks, you could end up with lower returns than you would have achieved with an index fund.
Research required: Investing in individual stocks requires a lot of research. That takes time, experience, and patience, and not every investor has those traits.
More volatility: If your portfolio consists of a handful of individual stocks rather than hundreds like in an index fund, it’s more likely to experience volatility. These ups and downs might not matter if you’re investing for the long term, but they can be problematic if you need to pull money out of your portfolio.
Diversification is more difficult: While achieving diversification is possible with individual stocks, it takes a lot of work. You need to look at correlations between stocks and think about the full spectrum of market sectors.
Index Funds: Pros and Cons
Simplicity: One of the key advantages to investing in index funds is that they’re simple. Many brokers let you set up recurring investments so you can gradually move more money into index funds, and you don’t have to do much research or worry about the performance of any individual stock.
Reliable performance: Index funds are also reliable performers. The S&P 500, for example, has returned an average of nearly 14% per year over the past 10 years. In the long run, index funds have been shown to outperform many more complex investment strategies.
Instant diversification: Since you’re investing in hundreds of different companies at once when you buy an index fund, you get instant diversification in your portfolio. That diversification can provide a buffer when the market suffers a downturn.
Lower volatility: While the stock market as a whole can experience volatility, the magnitude of the swings involved is typically much smaller than for individual stocks. So, even on their worst days, index funds rarely lose more than 2-3% per day.
Modest returns: Index funds are designed to match the performance of the overall market. They may not underperform, but they’ll also never outperform. Index funds may produce returns that are just a fraction of the potential returns from top individual stocks.
Limited control: You have no ability to customize what’s in an index fund. You can either invest in all of it or none of it. On top of that, many index funds use weighting schemes that mean that most of your investment might be in just a handful of stocks.
Management fees: Index funds charge annual management fees, also known as expense ratios, that can be 0.25% of your investment or more.
Limited personal growth: Learning to research stocks and build a diversified portfolio is a key part of becoming a more knowledgeable investor. When you invest in index funds, you miss out on an opportunity to learn and grow.
Examples of Individual Stocks vs. Index Funds
To show you how different the performance of individual stocks and funds can be, let’s take a look at some examples.
First, let’s look at index funds. The Vanguard S&P 500 index ETF (VOO) is the most popular S&P 500 index fund in the world and it has a 5-year return of 132%. The Invesco QQQ ETF (QQQ), which tracks the NASDAQ 100 index, has a 5-year return of nearly 250%.
How does those stack up against individual stocks? It depends a lot on which stocks you look at. Amazon, which is weighted heavily in both the S&P 500 and NASDAQ 100 indices, is up 343% over the past 5 years. Apple, also on both indices, is up 469% over the period.
Of course, some stocks in the major indices underperformed the average. AT&T, which is part of the S&P 500, is down 33% over the past 5 years. 3M, the manufacturing giant and S&P 500 constituent, is up by just 11% over the past 5 years.
Individual Stocks vs. Index Funds: Which is Better for Investors?
Whether individual stocks or index funds are right for you depend on your investing style and goals.
Investing in individual stocks might be better if you:
- Want to learn how to research stocks
- Want complete control over your portfolio
- Have a higher tolerance for risk
Investing in index funds might be better if you:
- Prefer simplicity
- Have a lower tolerance for risk
- Don’t want to spend time researching stocks
Conclusion: Individual Stocks vs. Index Funds
Choosing between investing in individual stocks vs. Investing in index funds is one of the most important decisions investors need to make. Both styles of investing have advantages and disadvantages, so you’ll need to think carefully about your investment goals and tolerance for investment risk.