Is it better to buy index funds, or can you build your own stock portfolio? There are multiple reasons why choosing either of these options could prove more beneficial for you. Whether you’re a novice investor or already well-versed may also play a role.
To determine which option suits you better, you must consider your acceptable level of risk and desirable level of returns. From there, you’ll be able to decide how to proceed. But first, take a look at this general comparison.
What is an index fund?
If you’re at least a bit interested in investing, you already know what stocks are – a security that represents the ownership of a fraction of a corporation, and an investment vehicle – all in one.
To be fair, index funds have been around for long enough and are also popular enough that you’ve no doubt heard of them, too. First created almost 5 decades ago, the concept requires that a mutual fund tracks a certain market index:
- A mutual fund is a professionally managed investment company that combines the assets of many people in order to invest into stocks, bonds and other investment options;
- A market index is a hypothetical portfolio that consists of either stocks or bonds and covers a certain segment of the financial market.
An index fund is a passively managed fund that does not try to beat the market. Instead, it follows and matches the market index within the theory that the market always wins.
What are the pros and cons of an index fund?
By tracking or matching the market index, an index fund is able to offer its investors lower expenses and diversified investments – because you buy the index fund instead of each separate stock, it helps you reduce transaction fees.
If you read our recent blog entry, you already know how a diversified portfolio can help protect you from unsystematic risks. However, when buying single stocks for your portfolio, you’ll have to invest a much larger amount of funds to achieve the level of diversification an index fund may be able to offer you for a fraction of a price. This is once again due to the fact that you purchase the index fund, not single stocks.
Another one of the more important pros is that index funds follow a passive investment strategy. This also helps reduce the cost of the service as the index fund manager takes the more passive role of following a market index instead of researching and selecting individual assets.
Undoubtedly, index funds possess certain cons as well. One of these is lack of control and flexibility. Even though generally an index fund will offer you a wide range of diversity, you have no control over the holdings within the funds nor can you control the transactions within.
Depending on your risk tolerance, market risk can be considered as another con. Yes, an index fund will cover a wide segment of the market, thus making your investment diverse. Nevertheless, if the market crashes, it may affect a significant portion of the fund’s holdings.
Additionally, an index fund can only be traded daily at market close. Therefore, if the market crashes after breakfast, the index fund manager will be unable to do anything about it until the market closes in the afternoon.
How do single stocks compare?
To the benefit of this article, the pros and cons of choosing your own stocks actually have a strong correlation with investing in an index fund.
For example, a valuable benefit of investing in single stocks is – actually knowing and understanding what exactly you invest into. Generally, experienced investors tend to research and/or like the stocks they buy. Investing in an index fund, you would never be afforded such luxury. The best you can hope for is finding an index fund that follows SOME of the stocks you want.
Unlike with any mutual fund, buying your own single stocks grants you freedom and control over your investment. It is you who decides when to buy, when to hold and when to sell. This, in order, can help you both mitigate potential losses and earn more. If you put enough time and effort into research, having single stocks in your portfolio can be more profitable than any mutual fund.
Unfortunately, sometimes time and effort isn’t enough. Both systematic and unsystematic risk poses a threat to your investment at any time. While you can’t really do anything about systematic risk, unsystematic risk can be mitigated. If you plan to build your portfolio from single stocks, it can be rather expensive to diversify. Less diversity can in turn create more risk to your portfolio. If your investment allowance is limited, you will have to compromise your portfolio.
And sometimes… there isn’t enough time (for effort). Buying single stocks can require you to spend more time than you may be able to. Active management of your portfolio can be time- consuming and may not suit everyone.
If you’re inexperienced, it can be difficult to properly manage your stocks. For example, if your stock suddenly dips, you might be enticed to panic-sell to mitigate your losses, whereas an experienced investor would perhaps hold. Your emotions can be the difference between making profit or losing everything.
What it comes down to
It’s really down to whether you can afford to build a diversified portfolio on your own. Both financially and time-wise.
If you have limited financial resources, or you wish to limit your long-term risk and increase long-term profit, index funds may be your best options. Index funds are often used for retirement accounts, allowing you to access solid stocks at a lower cost.
You will save time and, perhaps, yourself some stress if you invest in an index fund. While the profit margin won’t be as much as a single stock might potentially be in the short term, in the long term, passively managed index funds tend to outperform other investment vehicles.
If you have a taste for something more active, you can try an index ETF, which is an exchange-traded fund that also tracks an index. An index ETF differs from an index fund in that you can day-trade the index ETF, just like stocks.
However, if you possess the time and resources to build your own investment portfolio – go ahead. At your own peril, of course. Single stocks can be more profitable, especially in short term investing. But keep in mind – the modern portfolio theory dictates that you must diversify your portfolio in order to reduce risk and increase returns.