Pros and cons of index funds vs stocks
Many people are sitting on the sidelines of investing because of fear. If that’s you, here’s why you should consider investing in index funds vs stocks.
Why index funds vs stocks are the way to go for most of us
According to the Los Angeles Times last year, less than half of all Millennials own stocks directly or through mutual funds or retirement accounts. That means that the majority of younger professionals have missed out on the stock market run of the past 10 years!
When polled, many people say that fear is the number one reason they’re sitting on the sidelines. Having witnessed the financial crisis of 2008, it’s hard to blame them. However, while picking individual stocks can seem complex and daunting, index funds are a great alternative and provide a simple way to invest in stocks.
This guide will walk you through the pros and cons of investing in index funds vs stocks, but let’s first understand the differences between index funds and stocks.
Take something with you! Get the free Super Simple Investing Guide here and follow along.
Different ways to invest, including index funds and stocks
We’re focusing exclusively on investing in the stock market here, but it’s important to recognize that stocks are only one of many different assets that you can invest in. Other options include bonds, real estate, cash, commodities (like gold), derivatives, other financial instruments, and even cryptocurrencies, all of which are talked about at length here.
It’s important to realize that leaders at investment firms like Vanguard and Fidelity typically don’t recommend that you have 100% of your investments in equities (a fancy word for stocks). Investing in other asset classes will provide diversification, which can make your portfolio less volatile.
Get 4 key tips for investing in volatile markets on this Queer Money®:
Diversification works because the returns of different asset classes or types of investments have different correlations with stock returns. This helps you balance risk with reward. For more on diversification, asset classes and asset allocation, get the free Super Simple Investing Guide here.
With that said, let’s jump right into stocks so that you can learn how to start investing!
What are stocks?
Stocks are just ownership shares of companies. That means that if you own shares in Apple stock, you literally own a part of the company.
Companies are the economic motor of the global economy. Companies create products, generate jobs and facilitate global trade. As a result, investing in stocks has historically been one of the most effective ways to invest your money. After all, when it comes to money, the goal of investing is to generate a positive return.
Investors invest in stocks to generate investment returns in two basic ways: stock price appreciation and dividends. Price appreciation refers to the increasing price of a stock over time. If you buy a stock and it increases in price by 5%, your investment is now worth 5% more.
Theoretically, the value of a stock is based on the underlying fundamentals of the business (sales growth, income growth, customer growth, industry growth, effective management, competitive advantages, contracts and profits). So acquiring stock in a business that’s going to do well, in the long run, is the goal for many stock investors.
Many stock investors are lured by the prospect of investing in the next Apple or Google. However, it’s easier said than done.
Dividends, on the other hand, can simply be described as earnings or accumulated profits that companies pay to shareholders. Not all companies choose to pay dividends, while others pay a fixed dividend. These payments are the second way that stock investors generate their investment returns.
Hear 5 ways to start investing on this Queer Money®:
With that, let’s explore index funds.
What are index funds?
While sounding complicated, index funds are nothing more than a group of stocks that you can buy as a bundle. As opposed to buying individual stocks, indexes allow you to ‘purchase’ many stocks at once.
In a lot of ways, it’s like buying a stock that’s comprised of tiny slivers of many different companies.
The definition of an index fund, according to the Debt Free Guys, is ‘a mutual fund or exchange-traded fund (ETF) designed to track a previously aggregated basket of underlying investments designed to track various segments of the stock market and, in part, the economy.’
What that means is that index funds track or mimic the returns of a group of stocks like the S&P 500 (the 500 largest U.S. publicly traded companies) or the total U.S. stock market.
Index funds also allow you to invest in specific sectors or types of companies. For example, you can invest in small-cap stock index funds, growth stock index funds, dividend stock index funds, etc. There are tons of different options available.
The beauty of index funds is that by investing in a wide array of stocks at once, you’re diversifying your portfolio. Diversification is an investment best-practice that allows you to lower the volatility of your portfolio.
In other words, more diversification generally means less risk.
Here are 5 more ways to get started with investing:
So, then, index funds vs stocks
When it comes to exploring the difference between index funds vs stocks, it’s important to realize that they are similar in many ways.
Both types of investments let you invest in the stock market and hopefully generate positive investment returns over a long time horizon. However, mutual funds and index funds are different in that they aren’t traded in real-time.
Unlike stocks, mutual funds trade only once per day, after the markets close. That means that if you place an order to invest $500 in an index fund at 9 A.M., your order won’t take place until after the trading day is over. Individual stocks, and ETFs, on the other hand, trade throughout the day and during extended trading hours.
Next, when you invest in an index fund, you’re essentially purchasing directly from the index fund itself. However, with stocks, you’re buying and trading stocks on the secondary market.
That means you’re buying and selling stocks from other investors and not the company. That’s to say that if you buy stock in your favorite company, you aren’t actually giving money to the company itself to purchase a slice of the pie. Instead, you’re paying the seller of the stock.
In practice, that distinction shouldn’t really matter, but it’s important to understand what you’re buying.
Another key difference with index funds vs stocks is fees. Index funds charge fund fees. You can look up the fees for index funds by looking at their expense ratios.
These fees go to pay the companies that put the funds together. Some index funds have extremely low fees (Fidelity even has their own stock index funds with no fees).
For further help, get the Super Simple Investing Guide here.
Pros of index fund investing
In general, the pros of index fund investing revolve around simplicity and ease of use. With as few as two or three index funds, it’s possible to assemble a solid investment portfolio that rivals those made by professional advisors. This makes your investments easier to track, monitor and rebalance.
- No need to worry about beating the market
- Simple passive strategy
- Avoid having to pick individual stocks
- Easy to make a diversified portfolio
Cons of index fund investing
- Fees associated with funds
- Less flexibility if you want extra exposure to specific stocks or industries
- You’ll be tracking the market so you won’t beat it
Pros of investing in individual stocks
The pros of investing in individual stocks revolve around the amount of control you have in crafting your investment portfolio. This is ideal for the thrill-seekers who want to try to beat the market.
- Ultimate flexibility in the specific stocks you own
- No fund fees (only trading fees)
- If successful, you can beat the market average
Cons of investing in individual stocks
- More likely to have a more risky portfolio (all of your eggs in one basket)
- Have to be very deliberate to get good diversification
- The average individual investor doesn’t beat the market once trading fees are included
Active vs passive investing with index funds vs stocks
Did you know that your investment strategy will likely influence whether it makes sense for you to invest in individual stocks vs. index funds? Before getting into the specifics, let’s explore two common investment strategies to see how they stack up.
Active investing is an investment strategy that uses the frequent buying and selling of investments with the ultimate goal of maximizing returns. Active investing requires the constant monitoring of assets to take advantage of market conditions opportunistically.
Active investing is typically compared to passive investing, which refers to the purchase and subsequent holding of investments for an extended period of time. This strategy is sometimes referred to as a “buy and hold” strategy.
There are pros and cons to both active and passive investing. A benefit of passive investing is that it doesn’t require frequent monitoring. It’s a much more hands-off approach, which is ideal if you aren’t looking to spend a lot of your time glued to your phone or computer.
On the other hand, passive investment strategies typically rely on index funds, which means that you can only realistically expect to match the average market return. If you have the hopes of beating the market, then an active strategy might seem more appealing.
However, it’s worth noting that the potential transaction costs and tax consequences of frequent buying and selling can quickly erode your earnings and make it that much harder to keep up with the market average. It’s safe to say that, on average, a passive strategy is more conservative.
So which investment strategy do you think would be best executed with individual stocks? If you answered ‘active investing,’ you are correct! The goal of active investing is to beat the market average, so buying and selling the index may be a little counterproductive, since an index includes so many different stocks.
If you plan to trade index funds actively, your best bet is to focus on index ETFs since they trade throughout the day like stocks. Index mutual fund orders are only cleared at the end of the trading day, so your active strategy will be hard to execute if you are hoping to enter and exit investing positions in a very short period of time.
On the other hand, if you passively invest, putting all of your eggs in one basket could mean disaster if you pick an individual stock that ends up performing very poorly. For that reason, passive investors rely on index funds since they are diversified and don’t require constant monitoring.
How to decide between index funds vs stocks
If you’re having a hard time deciding whether you’d like to invest via index funds vs stocks, you don’t necessarily need to choose. You don’t need to pick one strategy or the other. You can use both or any combination of the two.
Want to mostly invest passively via index funds but want to buy stock in your favorite company? Go for it.
At the end of the day, your investments must reflect your ability to accept risk, your appetite for risk and your financial goals.
If you’re newer to investing and want to invest passively, then index funds make a lot of sense. If you fancy yourself as a stock-picking whiz, then you’re probably already trading individual stocks and understand the underlying risks associated.
If you’re still feeling confused and would rather have someone else handle the investing for you, then robo-advisors like M1 Finance or Acorns could be perfect.
If you’re an investor who likes to go it alone, open an account with M1 Finance. It’s free for retirement accounts with a minimum of $500 and can be accessed by clicking here.
M1 Finance is a super platform with automated features and is great for individuals who are comfortable managing pre-built and customized Exchange Trade Funds (ETF)-based portfolios. However, they can model pre-built portfolios by Wall Street experts and robo-advised models.
- Trading is free
- There are no asset under management (AUM) fees
- There are no account fees (for brokerage accounts with a minimum of $100 and retirement accounts with a minimum of $500)
M1 Finance also allows for socially responsible investing, which is huge for the queer community.
Too broke to invest? Wrong. There’s a way, and that way is investing through Acorns here!
With its spare change savings tool and cash-back rewards, Acorns lets account owners invest in taxable and, for your purposes here, retirement accounts with as little as $5. It’s a great way to start investing if you think you don’t have enough money to start investing.
Blooom (for your 401(k))
Get investment help from Blooom. Your investment options in company-sponsored retirement plans, such as a 401(k), 403(b) or 457. are often limited but even then, it can be hard to pick and manage the investments that are right for you because there are so many things to consider.
Don’t worry about it! Let Blooom worry about it for you – you be the supervisor.
Let Blooom do a free 401(k), 403(b) or other company-sponsored retirement plan analysis for you, then do the research and provide you truly unbiased advice to build a portfolio that best suits your short- and long-term retirement goals based on the investments that are available to you in your employer plan.
If you have a Traditional or Roth IRA at either Vanguard, Fidelity or Charles Schwab, it can help you manage those accounts, too.
Regardless of the method you use to invest, the most important thing is simply to make sure you invest!
So what are you waiting for? Go on and make your money work for you!
Get more investing tips here:
Other resources for investing:
- 10 Steps to Super Simple Investing
- How to Retire? 21 Tips for Financial Planning for Retirement
- Here’s How to Pay Off Credit Card Debt Fast!
Camilo Maldonado is a personal finance expert and the Co-Founder and CEO of The Finance Twins. He has been featured on Forbes, Business Insider, CNBC and US News. Camilo earned an M.B.A. from Harvard University and a B.S. in finance from the Wharton School of the University of Pennsylvania.