So, you’re ready to start investing—awesome! Maybe you’ve always had an interest and finally learned how to get started using the helpful tips in this article: How to Start Investing in Stocks. Or maybe you’ve diligently climbed out of debt over months or years and are ready to take the next step letting compound interest work for you instead of against you. Either way, pretty early on you’ll be faced with choosing between investing in index funds vs individual stocks.
Just to be sure we’re all on the same page, I think it’s a good idea to define what individual stocks and index funds are, to help you make a more informed choice. When you choose to purchase individual stocks (or shares) in a company, you’re purchasing ownership of that singular company. If you buy shares of Apple stock, you have quite literally become part owner of the company. Pretty straight forward.
Index funds are quite similar to stocks. Here’s a simple way to conceptualize them:
Think of an index as a category that individual companies can be placed inside of
The best way to think of an index, as it relates to stocks and investing, is as a category that individual companies can be placed in. Most categories you can think of will likely have a mutual fund or ETF that represents it, comprising only companies that fall within that narrow category. The most famous example might be the S&P 500, which as the same suggests, represents the 500 largest U.S. companies on the stock market across a broad range of sectors like tech, finance, energy, healthcare, and others. There are index funds with only small companies, and there are some that represent mid-sized.
You can find index funds wholly unrelated to the size of the companies, and instead focuses on companies exclusively in industries like finance, energy, healthcare, tech or any other. Want an index fund representing only companies with women as a CEO? It’s there. There’s literally thousands of index funds that represent collections of companies categorized in any number of ways.
Hey Ozzie, that’s awesome and everything, but which one is the better choice?
Well, the answer isn’t quite so straight forward. I mean, it’s straight forward for me, but the same factors might push you toward the opposite choice. Don’t worry, I won’t leave you hanging. It always bugs me when I ask a direct question to someone in a position to give me a direct answer, and instead I get some ambiguous response.
Here’s your straight forward answer:
If you want to cut right to my recommendation, choose index funds.
That’s right. If you want my quick recommendation, knowing absolutely nothing about you, your investment goals, your investment mindset, your risk tolerance, or where you’re starting out, I’d urge you to go with the safer bet for your hard-earned money. That is unquestionably the route of index funds. I won’t recommend any specific index fund, just like I would never recommend an individual stock. Just choose something broad and diverse like VOO, FSKAX, or something similar, and invest a little over time each month.
Hey Ozzie, okay, but do you really need to choose? Can’t you purchase both? What conditions would you recommend going with individual stocks? If index funds are safer, why qualify the answer at all?
All big questions that are surprisingly difficult to answer, because there’s no real objective right choice to make between the two options. Don’t misunderstand me, though. There is a right answer, but it’s not objective. It will come down to you as an individual.
One of the most important things to know about investing in general, no matter what you choose, is that investing (particularly in the stock market) is a very emotional endeavor. It is difficult to strictly logic your way to ‘staying the course’ through inevitable volatility in the overall market, let alone larger swings from individual companies. So, the first step in choosing which investment vehicle is best for you is to ask yourself a few important questions:
- How risk averse are you?
- Do you have a deep knowledge of any particular industry?
- Do you have another major/primary investment resource (real estate, art, etc.)
- What is your current financial situation?
- How old are you?
- Do you have anyone that depends on you and your financial wellbeing?
These questions are just a start, and you should absolutely jot down any others that might have popped into your mind while reading them. Depending on how you answer these big questions, the better choice will become clearer for you. Let’s dig into these questions a bit, paying special attention to number one because, in my opinion, it is the most important factor in choosing between the two.
How risk averse are you?
Put another way, what is your risk tolerance? If you tend to be more risk averse with your money, then index funds are definitely the better way to go for you, particularly if you choose indices that cover a broad range of companies like the S&P 500. Investing this way, you’re betting more on the success of the United States as a whole, as opposed to any individual company. That has much lower risk potential.
Now let’s suppose you are the opposite, and are willing/comfortable/able to take more risks financially. Well, the better choice just might be picking individual stocks as opposed to an index fund. Why? Well, the answer is pretty simple; you won’t find a broad index that will give you the types of gains you can make by picking the right individual stocks. Sure, the chance for greater losses is true as well, but that’s the game you play betting on individual stocks. And make no mistake, buying individual stocks—no matter which company—is a bit like gambling.
Here’s a good illustration for you. Suppose you bought and held shares of an S&P500 index fund over a ten-year period between 2015 and 2024. You would have experienced an average annual rate of return of 12%. That’s flat out amazing, given this is the ‘safe’ option. There’s no checking or savings account that would come close. Now let’s suppose you chose instead to go all in on an individual company, say, Apple, and held that single stock over a similar ten-year period, from March 2014 to March 2024. You would have experienced an average annual rate of return of about 22%. That’s a ten percent difference. Telsa’s ten-year annual rate of return over that same span of time is closer to 33%.
To put that into some real numbers, a single $10,000 investment into an S&P 500 index fund over that period would have grown to about $31,000. That’s awesome. A $10,000 investment in Apple would have grown to a whopping $73,000. Amazing! That same $10,000 investment into Tesla would have grown to around $173,000. We’re firmly in unicorn territory here.
That almost seems like a slam dunk no-brainer in favor of individual stocks, right? Well, not so fast. In fact, I’ll let you know right now that the vast majority of my personal investments are in an index fund, not any individual companies. Yup, that’s right. The reason? Risk!
The best example I can give would be Lehman Brothers. At the time it went bankrupt, it was the fourth largest investment bank in the world, right up there with financial titans like Goldman Sachs and JP Morgan. I can’t understate just how impossible it was to imagine that company failing even a year before their eventual bankruptcy. If you had that same $10,000 investment with Lehman Brothers when it failed in 2008, you would have lost virtually all of your money. Many people lost their entire life savings. If it can happen to a company like Lehman Brothers, it can happen to any company. Any company. Smaller companies go bust more often than you might imagine.
The other questions are more subjective
The other questions I have posed are more subjective. Considerations like your age can make you feel more inclined to lean one way or the other. Maybe you’re young and feel like you have the most enviable investing asset on your side—time. Time on your side might mean you feel you can handle potential losses better now, so you feel more comfortable going all in on an individual company despite the risks.
Or maybe you’re getting into investing later in life and feel you don’t have the time necessary to play things safe. Maybe you need to find the next Tesla, or Apple, or another similar company and ride the unicorn straight to the moon. This is certainly not my style of investing, and I wouldn’t recommend it, but someone might come to the conclusion this is the perfect choice for them.
Maybe your deep knowledge of an industry allows you to confidently predict the next unicorn company. Or maybe that deep industry knowledge solidifies your confidence in the entire sector and you go out an find an index fund that represents that particular industry that you know so well (energy, technology, healthcare, finance, etc.). Think through all the other factors I’ve listed and others that I haven’t included that might be important to you. Really give it some thought.
Having said that, in general, for most people (including myself), I would always recommend finding a broad index fund and investing there for the long term. After all, as unlikely as it might seem for a company like Apple or Tesla to fail, there’s always the Lehman Brothers cautionary tale. It can happen. It does happen. If you chose to invest in an index fund that covered big tech companies, it would include Apple and Tesla, but also Google, Microsoft, Amazon, Nvidia, etc. The chances of all those companies failing would be nearly impossible. And if they all did, well, one of my favorite sayings is if you chose to invest in the S&P 500—the 500 largest U.S. companies across a broad range of sectors—and you lost all your money, well, we all have much worse problems to deal with at that time than our investment portfolios right?
