Deciding to take the leap and invest for your long-term future is one of the best decisions to make to build a life of financial independence.
However, with so many options and methods to invest, deciding how to put your money to work becomes a difficult decision to make. Whether you are a fan of Jack Bogle and using index funds as passive investments or prefer the Warren Buffett strategy of making individual stock picks, determining which method of investment is key to getting started building a passive income portfolio.
The key to deciding whether you should pick individual stocks or just put money away consistently in index funds is to take a step back and analyze your own personal interest in the homework required to pick stocks as well as your track record. The second part of the requirements is perhaps the most difficult.
Honestly Assess Your Performance
Many people who make individual stock picks tend to have selective memory and ignore their losers and only think about how a certain stock they picked shot up in value while the rest of their portfolio lay in anguish and is pulling down their returns compared to the S&P 500 or other benchmark.
Therefore, if you do wish to pick individual stocks, you must first demonstrate a track record of beating the market. Otherwise, your energy could be best served in other capacities such as building other passive income streams or picking up extra work at your current job.
However, if you can demonstrate the ability to select stocks that outperform the market over the long-term, then picking individual stocks can be both enjoyable and financially beneficial to juice the returns of your portfolio.
Building Wealth Through Index Funds
Index funds offer a convenient and low-cost way to essentially “ride the market.”
With every dollar invested, the fund will increase and decrease with whichever benchmark the fund is designed to mimic. The most common index that these funds track is the S&P 500 which is a measure of the 500 or so largest companies in the United States by market capitalization. The financial community views the S&P 500 as representative of “the market” and as the primary benchmark to compare and beat.
Other indices include the NASDAQ Composite, Russell 2000, Dow Jones Industrial Average, or international indices such as the FTSE 100, DAX, Shanghai Composite, or NIKKEI 225. Each of these indices track particular companies or types of companies.
For instance, the NASDAQ is typically full of technology companies which are on average higher-growth oriented companies.
Alternatively, the Russell 2000 is comprised of primarily smaller capitalization, U.S. based companies for those who wish to have a basket of companies which may grow into the next Apple or Amazon. The FTSE 100, DAX, Shanghai Composite, and NIKKEI 225 are comprised of European and Asian stocks for those seeking international exposure.
How Does Indexing Work?
Index funds are designed pool investors’ money and allocate a portion of each dollar contributed into the stocks of the companies that make up each respective index.
With index funds, investors achieve diversification at a very low cost compared to buying each stock of the index at a fee of $4.95 or more per trade and continually rebalancing. Most brokerages offer certain index funds commission-free, so investors are able to purchase even just one share without their investment returns being impeded by fees.
Unlike mutual funds, most index funds do not have managers independently choosing certain stocks or sectors as they have a proscribed methodology for choosing the stock to buy and sell in order to rebalance to track the desired index.
Therefore, investors should not see the loads and fees that mutual funds charge within their index funds. This reduces the overall cost of ownership to nearly zero.
Index Funds Trade During the Day
Index funds also allow intra-day purchases and sell orders as they continually rebalance throughout the day. Unlike mutual funds which settle and rebalance at the end of the day, index funds allow a sell order to be executed in the middle of the trading day at specified prices rather than the closing price of the mutual fund after it rebalances.
While both mutual funds and index funds are liquid investments, index funds offer a bit more flexibility as far as the price paid or sold.
Index Fund Managers Follow Strict Criteria
As mentioned above, index funds do not have an independent portfolio manager who is making independent investment decisions that takes judgement and years of experience which may not be the worst thing.
While index funds offer consistent returns, some mutual fund managers such as Peter Lynch of the Fidelity Magellan Fund have been able to identify strategies that beat the returns of the stock market. However, according to CNBC, over a 3-year period, only 5% of mutual fund managers were able to top the S&P 500 each year.
Odds are if you have chosen a winning mutual fund in one year, the fund will underperform the market in the subsequent year.
Consistent, Returns That Track a Given Benchmark
With index funds, the investor will never outperform the benchmark.
However, they will also never underperform the benchmark in subsequent years which could offset any gains in picking mutual funds that had previously outperformed. However, certain indices tend to outperform the S&P 500 or “the market.”
For instance, the NASDAQ has outperformed the S&P 500 by around .5%, 11%, and 26% over the last 1, 2, and 5 years at the time of this article. However, in certain time periods, notably the “tech bubble” around 2000 – 2001, the S&P 500 trounced the technology-oriented NASDAQ.
As previously mentioned, if your goal is to find mutual funds that beat the S&P 500, this could be a difficult feat unless you choose mutual funds that contain stocks that are higher-growth such as those found in the NASDAQ. If this method is chosen, the better methodology for comparison would be to track the performance against the NASDAQ since this would be the best proxy for performance.
Indexing Passively: Great for New or Low-Hassle Investors
Choosing to invest passively through index funds offers a low cost, no hassle, method to accumulate wealth that compounds over time.
Really, the only decision required is in the initial set up when deciding which brokerage company to use, which index you wish to track, and which funds track that particular index. Once these decisions are made, automatic drafts can be set up to draw money from your bank account or paycheck on specific days to dollar-cost average into the funds and begin building wealth for the long-term.
After setting up your account and contributing to the funds, there is little or no research and homework required as long as you are willing to stick to the game plan of investing when the market is up as well as when the market sinks.
Having the discipline to continue the strategy is the only requirement once you have chosen the indices you wish to mimic.
Building Wealth Through Individual Stocks
Individual shares represent a small sliver of the equity ownership in publicly-traded companies.
Buying individual stocks can be as equally rewarding as buying passive index funds. However, unlike index funds, you have the power to choose to allocate your funds in the best companies while not investing in the bad companies that would have otherwise been in a particular fund or benchmark.
The Power (and Detriment) of Choice
Through individual stocks, you can choose a basket of companies in a particular segment of the market that you believe is poised for growth, and if correct, these investments would bring superior returns to your portfolio compared to the overall benchmark which would also include an equal number of duds that underperformed the average stock.
Conversely, if the stock picks are done incorrectly or too much of a portfolio is one particular stock, the potential for loss is much higher.
Potential Diversification Issues
With index funds, the money is allocated across hundreds of stocks and the entire economy would have to collapse and be nonexistent for the fund to go to $0. Individual companies in the market go bankrupt every year which leaves the equity holders empty handed.
Should an investor have just a handful of heavily-levered companies or have a portfolio lacking diversification and weighted solely in a particular segment of the market such as oil and gas, when an economic recession occurs or the price of crude oil drops, this could spell disaster for this portfolio.
However, if done correctly in a diversified, well-balanced portfolio, the market risk and company specific risks can be mitigated within the portfolio through the ownership of the very best of the many different types of companies spanning the various industries that make up the market.
Other Benefits of Individual Stock Ownership
By choosing individual stocks, investors also have a deeper connection with the companies in which they are making an investment.
This direct interest should lead to more research into the overall business of the company which will make the investor more knowledgeable overall. By purchasing the stock in a company that you believe in, personally use, or view as a visionary world-changer, you will be more likely to listen to the conference calls, read the earnings and press releases, and analyze the related news for the company in which you own shares.
Over time, the culmination of learning what drives markets and how you can avoid panicking when everyone else in the market seems to find an ill-founded worry will help you be greedy when others are fearful. While it is nearly impossible to pick the market off the bottom, putting money to work at depressed prices will greatly enhance your overall returns in the long-run – especially if done in companies that are set to outperform the market anyway.
The only way to have the brass to buy more stock in the companies you love with your heard-earned money is to know the company you are buying, have analyzed its market and growth potential, and believe in the company’s mission and long-term purpose in the market.
This confidence will keep you invested as well as allow you the wherewithal to “double down” when the market goes into a frenzy.
Continually Research and Reassess Your Individual Stocks Compared to the S&P 500
While gaining knowledge and experience over time and taking advantage of opportunities when great companies’ stock prices go on sale, choosing individual stocks is only worthwhile if it generates excess returns over what could have been obtained passively through index funds.
Track and Benchmark Your Performance
Therefore, if you do desire to buy individual stocks, methodically analyze your returns versus what you would have if you had invested that money in the market.
Personally, I record both the price of the stock I purchased as well as the market price at the exact time I made the buy and measure the percentage gains or losses versus the market each month. This method keeps me accountable for the companies that I choose and helps me assess whether my picks have been worth the added effort.
As an aside, as of the end of February, my stock picks are up 13% versus the market in my Roth IRA. This is because I have chosen to concentrate my portfolio in technology and growth stocks given my current investment horizon, risk appetite, as well as the recent bear market in the NASDAQ near the end of 2018 and beginning of 2019.
I also believe the companies that I have an ownership interest will help lead the way in changing how business is done, payments are made, and how goods and services are purchased online and shipped to our door. Most of these companies have demonstrated consistent revenue growth for the last several years, profitability or the investment to obtain greater profits in the future, market share gains, and/or a leading vision in their respective industry through their executive teams or founders.
Choose an Investment Thesis
My investing thesis is founded in the belief that these companies will be the main drivers of returns within a given index and therefore, my portfolio should be more heavily weighted to these types of companies by cutting out the majority of the other companies in the index that are dragging down these winners.
However, should market sentiment shift and investors favor a more short-term thesis or if economic turmoil should ensue, these growth companies my fall harder and faster than stable businesses with high dividend yields as investors flock to safety.
In this case, my portfolio would underperform the market for a short duration. Because of these potential risks, while my portfolio is weighted more heavily for growth due to my time horizon, I also include a mix of diversified, well-established companies that pay dividends as well as index funds to offer stability and diversification.
Over the long-term of several decades, I believe my strategy will reward my portfolio with outsized gains, and I will continue to track the performance to test and reassess my strategy.
Which Should You Pick?
Determining whether to buy index funds or individual stocks is purely at the discretion of each investor, their time horizon and investing purpose, and appetite for risk.
Choose Index Fund for Tried and True Performance and a “Set and Forget” Strategy
Generally, index funds should be favored if an individual is unwilling to committee the time necessary to research specific companies or is not confident in their ability to pick individual stocks.
Index funds offer a great means to capture the market returns with little effort in a tax-efficient, low-cost vehicle that tracks a particular benchmark.
Choose Individual Stocks if You Can Outperform the Benchmark Over Time and Enjoy Research
Choosing individual stocks, by contrast, will require more effort in order to ensure you pick more market-beaters than market-laggers.
Considerable time may be required in the beginning when initiating a position and then continual homework should be performed to make sure the investment thesis holds true. For those that enjoy the process of researching companies and their businesses, purchasing shares in the various companies, and then tracking their performance will gain great enjoyment for watching a stock they own shoot up in value 20%+ in a single day unlike index funds which are rarely up more than 2%+ on a single day.
However, individuals who own individual stocks must also be willing to watch certain securities plummet by double digit percentages when earnings, court rulings, or other news does not go a particular way. If this potential for loss would cause the loss of sleep at night, stick with index funds as the bulk of your portfolio.
For the Vast Majority: Choose Index and Mutual Funds
In the end, most people would see the greatest benefit for their time and sanity of having the majority of their investments in an index fund or mutual funds for diversification.
If the bulk of their money is invested in these vehicles, a small portion can be allocated to buying 5 or 10 individual companies in the beginning to start seeing if doing the necessary work to own individual stocks is worth the time and effort. If you can establish a track record for beating the market, you can begin adding and allocating more money as confidence is gained.
As a general rule, most investors would probably be most comfortable sticking with index funds and mutual funds in their IRAs and 401Ks. While losing money is never fun, losing money in these retirement accounts can be especially disheartening and may dissuade someone from ever choosing to buy an individual stock again.
Losing money in an individual brokerage account is still real and painful. Contrary to losing money in a tax-advantage retirement account, the capital loss can be deducted on an individual’s taxes subject to certain limits in most cases. This at least lessens the sting of losing money on one particular investment while the winning stocks in the portfolio can continue riding the market up.