Individual Stocks or Index Funds?

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active management, index funds, individual stocks vs. mutual funds, mutual funds, lifecycle mutual funds, individual stocks

The following is a guest post by Karl Marrion, a money saver and investor who runs the blog, WiseStockBuyer. Enjoy!

Individual Stocks or Index Funds?


Thanks to the web, the average small investor has more options than ever before to invest his or her cash. Readily available information on any publicly held company is within any investor’s grasp within minutes, thanks to online tools like Morningstar.com, Bankrate.com, SEC.gov, and thousands of others.


In addition, there are dozens of stock brokerages that will let anyone buy or sell shares in specific companies. However, there are also dozens of index funds designed to take the hard work out of investing. 


Are you interested in individual stocks or index funds? Read on…


Individual Stocks: The Pros

·         You control exactly which companies you invest in. Unlike index funds (or any fund, for that matter), an investor can select only those companies he or she wants to own a part of, and skip the rest. By contrast, it’s pretty much a guarantee that an index fund might have a stake in a company that you despise. You know: the company whose current VP of Sales has a daughter that gave you the fake phone number at a club last month.

·         If you select a big winner, your returns will be significant. Let’s say you decide to skip investing in funds altogether, and instead buy shares in ten or twelve different companies – a common strategy. If 10% of your portfolio contains shares of the Next Big Thing (oil shale extraction is getting some attention these days – hint, hint); you’ll have a nice chunk of change.

·         You’ll be a stud at parties. And once Big Acme Oil Shale shares shoot up 500% in a week (sure, it happens…occasionally), you get to brag about the fact that you bought up shares before anyone else heard about the company! Congratulations, Warren Buffet, Jr.! That cute babe across the room just heard you, and is now sliding towards you.

·         You can get out of loser stocks more quickly. Now, let’s say that Big Acme Oil Shale’s latest drilling project in Canada just yielded a treasure trove of – sandstone! Get out, and get out quickly. Which you can do via most online stock trading sites. You probably won’t see any sliding babes any time soon, however.


Individual Stocks: The Cons

·         You don’t have a well-oiled research staff. Not only are the pros better at buying and selling stocks than you are, they have research teams, and you don’t. Oh, sure, you have the Internet: Twitter and Facebook will keep you abreast of what other amateurs think about a certain company (better hope none of those “amateurs” are trying to “pump and dump” a stock to their advantage!) But the big fund companies not only have well-paid researchers uncovering everything they can about Big Acme Oil Shale, chances are they have an “insider” who actually works at the company or knows someone who does. Is this illegal? Probably. Did petty legalities stop Enron? You know the answer.

·         If you have a small account you may get hammered with fees. Even the least expensive discount stock brokerages charge at least a pint of beer per trade, whether you are buying or selling. Now, if you believe that you are going to “buy and hold” an individual company’s shares for years to come, this probably won’t be an issue for you. But most individual investors get restless and yearn to get out of Boring Corp. and into Sexy Industries at the drop of a high-heeled shoe. You’ll probably do the same, and pay the trading commissions to do so.

·         Your significant other doesn’t care how you did in the markets today. Sometimes it’s fun to ride the market’s ups and downs; those who enjoy risk and adventure probably enjoy the roller coaster of the major markets as well. But your “better half” isn’t interested in what the markets did today, or most days. Don’t bore him/her with tales of your company’s conference calls or earnings reports. She’s more interested in the upcoming sale at the corner boutique; he wants to know if you’ll mind him joining his buddies for golf this weekend. By the way: your significant other might care how the markets did, if you’re betting with his or her retirement fund along with your own. So beware.


Index Funds: The Pros

·         Set it, then forget it. The best thing about investing in an index fund? You don’t have to do any work once you find the index that you want your money to be invested in. At this point, you’ll need to select whether you want to be in larger companies (S&P 500 index funds), or smaller companies (Russell 5000 index funds), or some other major market index. All indices have funds that track and mimic their holdings.

·         Actively managed funds don’t necessarily outperform the market. Not only are index funds nice because you don’t have to put any effort into researching companies, but they tend not to do much worse than so-called “actively managed” mutual funds. Actively managed funds are those where a manager or team of experts pick and choose companies to invest in, or get out of. By contrast, index funds only invest in companies that are actually included in the index that they track. For example, a Dow Jones Index Fund only buys companies that appear on the Dow, period. This means that you can expect an index fund to have…

·         Low fees. Because so little research goes into index funds, their fees tend to be lower. This is more important than you think. Higher fund fees (and the commissions on trades of individual stocks) can eat into your portfolio’s value over time, and significantly. Unfortunately, talking about low fund fees doesn’t make for exciting nightclub chatter. Sorry.

·         If there’s an Enron in the mix, it won’t hurt you very badly. Yes, it’s been a number of years since Enron “blew up” and took some of the market down with it. But you can bet that as long as there are humans, there will be more Enrons. Odds are, you might get into an index fund that owns a little bit of the next Enron. Odds are, however, that it will only make up no more than 2% of the entire fund’s overall value. This means that your portfolio won’t be too damaged when the CEO shows up on TV in an orange jumpsuit.


Index Funds: The Cons

·         If there’s a Google in the mix, it won’t boost your returns very much. Just as a potential Enron won’t hurt you if it takes up part of an index fund, the next Google won’t help you much if it’s also part of the same fund. But you take the good with the bad; you’re looking for a decent return with moderate risk.

·         You won’t sound cool at parties. That Big Acme Oil Shale stock you want to brag about? Well, you can’t brag about it now, because you are a boring index fund owning geek. What a yawn you’ve become. Goodbye, cute babe across the room.

Keep in mind that market indices sometimes have long periods of mediocre performance. You’ll never know, of course, when one of these periods begins or ends. However, index fund investing is designed to make things easier for the small investor, so you shouldn’t spend any time worrying about when to get into, or out of, the markets.


Many small investors put the bulk of their retirement savings into index funds, while putting a little bit of “fun money” aside for dabbling in individual company stocks. Not a bad plan. Is this the plan you should follow? Every investor is different, and each investor is at a different period in his or her life.


Consider your own investing style, financial goals, and aversion to risk before making any decisions on where to put your money. And consider talking to that cute babe across the room about something other than stocks.


My personal approach

Personally, I prefer investing index funds rather than individual stocks. I like to get in after a big crash, when many investors are panic selling. I was a big buyer of index funds during the tech mess of the early 2000’s and the 2008-09 banking crash. I feel for me personally, this gives me a level of risk to reward that I’m comfortable with. Investing at these times takes a lot of nerve, as you are doing the exact opposite of what the masses are doing. Just remember one thing though, most traders are not making money, so you don’t want to be following them.


I use Optionsxpress as a brokerage firm. One thing I like to do when trading indexes is keep expense ratios as low as possible. When investing investing in the S&P 500 index, I use the Vanguard S&P ETF, ticker VOO. This is ETF has the lowest expense ratio of all the S&P trackers and it’s just 0.05%. Typically I have held positions for 6-18 months, depending on what happens in the market. As a general rule of thumb I tend to keep 50% of my portfolio in cash and the other half in equities and commodities.


***Photo courtesy of http://www.flickr.com/photos/argonne/4660306658/sizes/l/in/photostream/

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