Individual Stocks vs. Index Funds

When building an investment portfolio, are stocks or bonds the best fit for you? The answer depends on what you’re looking for and your financial goals. Individual stocks and index funds each have advantages and disadvantages you should compare before investing.

What Is Individual Stock Investing?

Image via Flickr by Nazir Amin

When you buy shares of stock in a company, you’re simply purchasing partial ownership of that company. As such, you get to share in profits and losses based on the company’s performance. You can profit in two ways:

  1. Each individual share becomes worth more than it did when you purchased it, leading to a profit should you choose to liquidate your shares.
  2. You receive dividends, in which the company takes a certain percentage of its profits and pays it to the shareholders. Your quantity of shares versus the total number of shares determines the percentage of the dividends you receive. 

The flip side of these scenarios is if the company fails or struggles and your shares’ value drops or becomes worthless. 

What Is Index Fund Investing?

An index fund is a collection of stocks purchased to track a particular index, such as the Dow Jones Industrial Average or the S&P 500. Owning shares in an index fund means you own individual stocks in a variety of companies indirectly. This alleviates the need to study individual companies to determine which stocks to purchase. Instead, you can analyze which index funds have performed well, buy shares in one, and let the fund managers do the legwork.

As a general rule, Index fund investing tends to be more favorable for individual investors due to their lower costs and reduced need for research and analysis. 

Index Funds Present Lower Risk

If a company fails, that information is part of the portfolio for an index fund, and the manager cuts their losses and replaces it with another company. The failed company is only a small fraction of the overall fund rather than the entire investment, similar to if you had invested in an individual stock. This inherently makes index funds much lower risk. If you invest heavily in an individual stock and that company struggles, falters, or fails, you lose your investment. Index funds mitigate this risk.

The best-known index is arguably the S&P 500. The odds of every company on that list failing are nearly impossible, even in a crash or recession. With the diversification inherent in investing in index funds, your risk is spread over hundreds or even thousands of individual stocks, thereby heavily reducing your overall risk. Another positive factor is index funds typically exceed the returns gained on other funds.

Index funds do not require the active management other funds and individual stocks do. The interaction and transaction fees are therefore lower, bumping your return up in the long run. And while there are no guarantees, index funds are likely to garner returns over time. 

Individual Stocks Offer Greater Potential

In return for the increased risk some individual stocks bring is the significantly increased opportunity for high returns in the short term. Some stocks can increase in price several times over a year. But those stocks are also the ones at greatest risk of going belly up. Therefore, it’s advisable to avoid individual stocks when just getting started investing. Putting most of your investment dollars into an index fund is much safer and will likely get returns over the long run.

Once you become more educated about the stock market and learn to analyze and research investments, you can diversify and delve into individual stocks. Research and analysis begin with examining the company’s bottom line, which includes doing a debt analysis and determining if they are exceeding or subceeding market expectations. You can find a plethora of credible online resources that offer insight into a potential investment company’s numbers.

Also, it is essential to assess your risk tolerance. Are the chances of losing that money worth the potentially large return on your investment? The market fluctuates heavily, and it isn’t always predictable. Thus, you can easily lose a lot of money in short order. However, with thorough analysis and research and informed investment decisions, you can also make substantial returns quickly. This is where index funds fall short, as they will never increase many times over in a year. It’s the basic premise of high risk, high reward vs. low risk, low reward.

The Best Approach

When deciding whether to invest in individual stocks or index funds, the best approach is to do a bit of both. Each strategy offers advantages and disadvantages. Investing most or all your money in individual stocks is risky and can lead to losing your investment capital. Investing exclusively in index funds is risk averse and offers much less in the way of returns.

Ideally, you want to keep most of your investment dollars in safer investments such as index funds. Keep the risk low, and gain slow but steady returns over time. Take the rest and dabble in more speculative investment opportunities. You have that potential to make a big profit with your educated investments in riskier individual stocks. But if you gamble and lose, the loss isn’t significant, and you can absorb it easily.

Doing your homework and finding those “diamonds in the rough” while keeping most of your money in the safer index fund strikes the perfect balance of risk vs. reward. The best investment strategy might be to put about 90% of your investment capital in proven investments such as index funds. Take the remaining money, do your research, and try to hit a big gain.

If you’d like investment advice or more information about our wealth management strategy, contact our knowledgeable team at 3D Partners Wealth Advisors. We serve Honolulu, HI and the surrounding communities. You can reach us from 8 a.m. to 5 p.m. at 808-707-8068 or fill out our secure online form. A team member will get back to you to answer any questions or set up an appointment to discuss your portfolio or financial plan.