“Only invest in index funds.”
“You should avoid index funds because there is a bubble.”
There’s no shortage of seemingly authoritative statements like this floating around the internet. The problem with these statements is that they don’t recognize nuance or how someone else’s investing goals may be different.
If that is the case, why would someone prefer one rather than the other? That’s what we will look to answer in this post.
But first, let’s make sure we understand what each strategy entails.
What is an Index Fund?
The first thing we should understand is what an index fund is. Simply put, an index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks a given index.
One popular example of an index is the Standard & Poor’s (S&P) 500. The S&P is an index that tracks the 500 largest US companies by market cap.
Note that index funds such as those that track the S&P 500 are not simply composed of stocks from each of those 500 companies. Instead, index funds look to mimic the performance of their given index.
Two popular index funds are Vanguard’s VTSAX and VTI, which actually track nearly every publicly-traded company in the US. Both track well over 3,000 stocks.
The biggest benefit of index funds is simplicity. They allow the everyday investor to invest in a single fund and gain broad exposure to hundreds or even thousands of companies.
This allows people to grow their investments while simultaneously reducing the volatility that comes with buying shares in just a handful of companies.
All of that can be done automatically once the initial setup is complete. For many investors who have busy lives, index funds have proven to be a great way to invest.
But that is not to say they are not without their drawbacks.
What is Stock Picking?
As you can probably guess, stock-picking refers to picking a handful of companies in which to invest rather than buying shares in an index fund.
One reason some people choose to invest this way is that not every publicly-traded company is a winner. If you can buy the winners and avoid the losers, you can realize a better return than you would buying an index.
Of course, picking winners is easier said than done, and picking only winners is nearly impossible. Still, some investors have been successful in investing this way and have indeed beaten the market in the long run.
While this style of investing can be more time-consuming than buying shares of an index fund, it doesn’t have to be. Day trading, for example, requires a significant time commitment, but if you buy and hold individual stocks, it’s possible to automate your strategy.
One way to do that is to use an app like M1 Finance. This app allows you to set up investment “pies.” You can fill up your slices with ETFs, bonds, or if you choose, individual stocks.
You’ll be able to set an allocation for each slice – say 5% in Tesla and 5% in Amazon. Then, when you make a deposit, your money will automatically be invested to match those allocations. M1 has fractional shares, so small dollar amounts are no problem.
Which Strategy is Better?
As you can see, we can’t really say that one is “better” than the other. Each has its own set of advantages and disadvantages.
If you don’t have much time to research individual stocks, you might prefer index funds. These funds may not provide the absolute best return possible, but they can come close to matching the market, which returned about 10%-11% per year from 1926 to 2018.
That figure is roughly three times that of inflation, so there is no reason to think your money won’t grow with index funds.
Nevertheless, some investors want the best return possible and don’t mind spending some extra time managing a portfolio of individual stocks.
But it’s important to note that these portfolios can be highly volatile. They may provide a higher return in the long run, but some ups and downs are much more likely.
As you can see, one strategy is not unequivocally better than the other. There are a number of factors that will affect which strategy you prefer, including your financial goals, risk tolerance, and how much time you can commit to managing your investments.
Once you determine these things, it will be much easier to figure out which strategy is ideal for you.
Either Or? Why Not Both?
There seem to be many dogmatic investors when it comes to these strategies, again, insisting it’s their way or the highway. However, you certainly aren’t required to choose one or the other.
After all, you shouldn’t forget about the tax advantages of investing as much as possible in your retirement accounts. And those accounts may not have the nifty tools that M1 Finance has, so you may find it easier to use your 401k to invest in index funds.
Technically, your 401k or IRA are not the most tax-efficient places to hold index funds, but the most important thing is to reduce your taxable income as much as possible.
Therefore, if you choose to first max out your 401k by investing in index funds or a target-date fund (TDF) and then hold individual stocks in a taxable account, you would still be setting yourself up for success.
Do What Works Best For You
There are many different investing strategies, and what works best for someone else may not work best for you. The best strategy is to find what works best for you and stick to it.
When you can find a winning strategy for yourself, you will find that your money starts to work for you instead of you always working for your money.
And that is perhaps the real goal is investing: to become financially independent and no longer have to worry about money.
How will you actually make that happen? Well, that is up to you to find out.
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Image source, EpicTop10.com, via Flickr.