Picking Stocks vs. Index Funds (Choose the Right Strategy)

When I first got into investing, I was excited. I wanted to learn everything there was to learn. (I still do.) So, I read about financial statements, different ratios, growth rates, discount rates, growth stocks, value stocks. I worked tirelessly.

But at some point, I almost let people get inside my head. People telling me I’m better off just investing in an index fund or that “most people can’t beat the market, so what’s the point of even trying?”

To me, that’s a soul-killing attitude, and one I whole-heartedly disagree with. You should always pursue what you’re interested in.

The problem isn’t getting above-average results. The problem is trying to get above-average results without becoming an above-average investor.

Now don’t get me wrong. I understand where the index fund proponents are coming from.

If you don’t want to learn everything about investing but still want to invest in the stock market, index funds are great. My point isn’t to undermine index funds in any way, my point is simply this:

Don’t let other people dissuade you from doing what you want to do by telling you what most people can’t do.

Your end goal when pursuing something you’re interested in probably isn’t to become like most people, so what most people can and can’t do is irrelevant.

By now, you can probably guess my preference when it comes to picking individual stocks vs. index funds. But the point of this article is to enable you to decide for yourself which strategy best suits you.

We will start by looking at picking individual stocks.

What type of Investor are you?

Whether you should invest in index funds or pick individual stocks largely depends on what kind of investor you are (or want to be) and your interests.

If investing is something you just feel like you have to do to grow your money, but you have no interest in it other than that. Then index investing might be for you. Index investing significantly simplifies the process of investing to the point that a monkey could do it.

Not that you are one if you invest in index funds. On the contrary, by being realistic with what you can hope to achieve without putting the necessary work in, you can outperform a multitude of people.

Relating to the above, this is one of my favorite Warren Buffett quotes:

When ‘dumb’ money acknowledges its limitations, it ceases to be dumb.

Dumb money is what Wall Street calls retail investors (you and me.) The fact that financial institutions are called smart money is quite funny. Especially since 80% of actively managed funds underperformed the S&P500 over 5 years according to SPIVA.

Imagine having a team of analysts, access to the latest technology and tools, and billions of dollars. And still not being able to outperform the index. No wonder index funds have become so big.

Sorry, I got a little side-tracked. If you on the other hand enjoy the process of investing, like reading about it, analyzing different companies, keeping track of your investments. Then a more hands-on approach like investing in individual stocks might be for you.

Don’t make your decision yet. In the next part of the article, we’ll dive a little deeper into the world of stock picking and index funds. Let’s start with the case for picking individual stocks.

The Case for Picking Stocks

When picking individual stocks, you get to construct your portfolio yourself. You get to pick how much risk you take on and how diversified you want to be. If you don’t want to own 30, 80, or 150 stocks, you don’t have to.

Perhaps you only want to own 5 to 10 different ones. Go right ahead. If a few of them turn out to be winners, you can potentially make huge profits. On the other hand, if a few of the eggs turn out to be rotten, you’ll be the one to suffer the consequences.

And that’s the beauty of stock picking. Your performance will be a reflection of how well you pick the right stocks (or the wrong ones.)

I don’t subscribe to the common notion that high returns are always a result of taking on a higher risk. Instead, I see time and effort put into the intelligent selection of stocks as the key factor determining results.

Now, stock picking comes with a lot of work (at least doing it the right way.) And many people just aren’t interested enough in the craft to do the necessary work. For those people, mediocrity or underperformance is a certainty.

If you’re not willing to put in the required work, I seriously think you should consider other alternatives, like index funds.

You’re not going to get good results by taking shortcuts. Like buying whatever is popular at the time, or what the newspapers or some blog tells you to.

Benjamin Graham said it the best in his book, The Intelligent Investor:

You may take it as an axiom that you cannot profit in Wall Street by continuously doing the obvious or the popular thing.

This is kind of self-explanatory but to put it in other words: You can not do what the average person does and expect to get above-average results.

If you want to know more about picking stocks, I have written an article about stock analysis here.

Pros and Cons of Investing in Stocks

As with all things, there are pros and cons to investing in stocks. Only you can determine if it’s right for you, preferably by weighing the pros against the cons and comparing them to those of other strategies.

Whether some things are pros and cons largely depends on you. Like in every aspect of life, seemingly advantageous things can turn into disadvantages by how you use them.

The ease with which you can buy and sell securities on the stock market should be a good thing. But if you don’t have the stomach or discipline necessary, you might be driven by your fleeting emotions to jump in and out of the market, racking up transaction fees.

The same goes for volatility, generally considered a bad thing. But with discipline and a strategy, you can use volatility to your advantage and buy cheap stocks in a crash instead of fleeing in panic.

Pros of Stock Investing

  • Stocks offer huge upside potential. IF you can pick the right ones, stocks are hands down the best investment option.
  • They don’t cost you anything to own. Unlike funds, stocks don’t carry an expense ratio (annual fee.) In the long run, even if the fees are small, they add up.
  • Stocks are highly flexible. You get to choose exactly what you want. Get some dividend stocks, and reinvest the dividends in aggressive growth stocks. Or why not go for a portfolio of value stocks? The possibilities are endless.
  • It’s easy to buy and sell them. Unlike mutual funds, stocks can be traded instantly. (That’s not necessarily a good thing.)
  • It’s fun! (For some people, at least.) And if you truly enjoy all the processes that come with stock picking, chances are higher that you’ll eventually get good at it.

Cons of Stock Investing

  • They are potentially riskier than other investment alternatives. It depends on you and how you construct your portfolio. If you don’t diversify enough, your portfolio can be extremely risky.
  • Stock investing requires a lot of work. First, you have to analyze and pick your stocks. Then you have to re-evaluate them regularly, and potentially sell them if they no longer satisfy your needs. (If you enjoy it, though, this goes in the pros-list.)
  • Investing in them requires mental toughness and patience. Without these two traits, owning stocks can be an anguishing experience. Especially in times of volatility.

Now that we have a general view of stock picking, let’s continue with index funds.

What is an Index Fund?

Before we get into the rest, let’s begin by learning what an index fund is.

An index fund is either a mutual fund or an ETF with a portfolio constructed to mirror an index. For example, an S&P500 index fund will buy all 500 stocks in the index while also mirroring the index weight of the stocks. E.g., if Apple takes up 6.7% of the S&P500, the index fund’s portfolio will contain 6.7% Apple stocks.

This type of fund is known as a market-cap weighted index fund. It’s the most common type of index fund, but there is also the less common equal-weighted index fund.

To use the S&P500 index as an example again. An equal-weighted index fund’s portfolio would split the 500 stocks equally. In this case, each stock would take up 0.2% of the portfolio.

Although following the same index, the two different types can behave very differently because of their composition. It isn’t unusual for the 10 biggest stocks in the S&P500 to take up 20-30% of the index, so these stocks’ performances will largely impact the market-cap-weighted funds.

There are many different kinds of indexes you could potentially choose from when investing. Here are some examples:

  • Company size. There are indexes tracking small, medium, and large companies. So you could get an index fund only containing small-cap companies.
  • International index funds. You could get a global index fund, or maybe a continent-based one tracking Europe. Or maybe a country-specific one, like a Japanese or Swedish index fund.
  • Sector-based index funds track a specific sector. Maybe you want to invest in healthcare or technology, just pick an index fund tracking the sector.
  • Different assets. There are index funds tracking domestic and foreign bonds, currencies, commodities, etc.

So now you know what an index fund is and some different types, but who are they for?

The Case for Index Funds

It’s not hard to understand why index funds are growing in popularity. They offer a way for investors to become adequately diversified with a single transaction and achieve average results with little to no work. But average results are also all you can expect to get.

There’s no shame in expecting average results, though. Many investors achieve far less than average while still putting in a lot of work. Another quote from Benjamin Graham’s The Intelligent Investor that always stuck with me goes like this:

It’s no difficult trick to bring a great deal of energy, study, and native ability to Wall Street and end up with losses instead of profits. These virtues, if channeled in the wrong directions, become indistinguishable from handicaps.

It’s so common in the stock market to mistake motion for progress. Some investors are active all day, doing so much but getting nothing done.

It always reminded me of Alice’s race against the Red Queen in the novel Through the Looking-Glass. In which Alice is running faster and faster but getting nowhere and the Queen says:

“My dear, here we must run as fast as we can, just to stay in place. And if you wish to go anywhere you must run twice as fast as that.”

This is not the case for people investing in index funds. They usually don’t participate in the different self-defeating behaviors common to the stock market, like trying to time the market.

They are usually the buy and hold-type of investors with a long time horizon, not caring about short-term stock prices.

If you want to know more about the costs and performances of index funds, I have an article comparing index funds to actively managed funds, and mutual funds to ETFs.

Now let’s go over some pros and cons of index funds.

Pros of Index Funds

  • Low fees. They carry low expense ratios when compared to actively managed funds. Since index funds are passively managed they require very little work and can therefore keep very low fees.
  • Good performance. Index funds outperform most actively managed funds in the long run. According to SPIVA, 80% of actively managed large-cap mutual funds underperformed the S&P500 over 5 years.
  • Low risk. Most index funds are inherently broadly diversified.
  • They require little to no work. You don’t have to spend time picking every stock you want to buy. You do have to pick an index fund, though.
  • Tax-efficient. Index funds generally produce much less capital gains than actively managed funds.

Cons of Stock Investing

  • Average results are all you’re going to get. You can’t hope to beat the market while mirroring it.
  • They lack flexibility. Although there are many index funds to choose from, they lack the flexibility that comes with picking individual stocks.
  • There’s a risk of buying when the market is expensive. When picking individual stocks, you can always find some cheap ones even if the overall market is expensive. That’s a luxury not afforded to index funds that buy everything, whether cheap or expensive. For example, if you bought the S&P500 at 1500 in 2007 before the crash, it would have taken 6 years for it to reach 1500 again.

Conclusion

Whether investing in index funds or picking individual stocks is right for you depends on your strategy, goals, and interests.

If investing is something you love doing, then strive to become the best investor you can. Do the necessary work and pick your own stocks. In the long run, your results will be a reflection of your skill as an investor, good or bad.

If you don’t have the interest or the time to really delve into the world of investing, index funds are a great way to gain exposure to the stock market.

While directly comparing performance and risk between investing in index funds vs. picking individual stocks is impossible since it all depends on the stock picker’s strategy.

Index funds are considered less risky, generally speaking, since you’re not going to see a lot of individual stock pickers with a portfolio containing hundreds of stocks

But on the other hand, an investor skilled in the art of picking stocks has an unlimited upside potential. They are masters of their own fates, so to speak.

On a final note, you’re not limited to either index funds or individual stocks. You can do both. If you believe index funds suit you best but you also want to pick your own stocks, then maybe construct a portfolio of 80% index funds and 20% stocks you have chosen.

I hope this article was helpful in your decision between index funds and stock picking. Whether you choose index funds, picking individual stocks, or both, I wish you good luck.

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