Index funds or stock picking: What’s best?
The market’s steep slide during the coronavirus crisis has exposed the pros and cons of buying individual stocks and purchasing index funds that provide exposure to a broad basket of stocks in one purchase — like people do with their 401(k)s.
If there’s a lesson in Wall Street’s rapid descent into a bear market for the first time since 2009, it’s this: There’s no such thing as risk-free stock investing, especially in the short run.
“Every investment carries risk,” says Arielle O’Shea, investing and retirement specialist at NerdWallet.
It’s the magnitude of potential price changes that investors need to be aware of when building portfolios. A single stock, for example, is subject to far greater share-price moves than, say, an index fund or exchange-traded fund that tracks the 500 large-company stocks in the Standard & Poor’s 500.
Since the S&P 500’s closing high on Feb. 19, the index has lost 32% of its value and all 11 major industry groups it tracks are in the red, S&P Dow Jones Indices data show. Losses range from a 22.4% drop for companies that sell consumer staples like toilet tissue and disinfectant wipes to a 61.8% plunge for energy companies.
But those declines, which are “average” losses suffered by dozens if not hundreds of stocks, tell only part of the story. Many individual stocks, whose businesses are particularly hard hit by fear, travel restrictions, social distancing and the economic shutdown due to the coronavirus, have suffered far greater declines.
Let’s review the pros and cons of both investment approaches.
Pros of equity index funds
Diversification. “When you buy an (S&P 500) index fund, you’re buying 500 stocks in a single fund, so that’s a pretty easy way to get exposure to a lot of different companies,” says O’Shea, adding that broad diversification is the “better choice for the vast majority of people who are saving for retirement.”
“Whereas, if you’re picking and choosing individual stocks, you have to do it one by one — and maybe need to buy 20, 30 or 50 stocks. You have to do a lot more work and due diligence.”
While investors will never generate better returns than the index their fund is tracking, they are more likely to match the long-term 10% average annual returns of the S&P 500 by buying and holding an index fund over, say, a 10-year period, than they would trading stocks on their own, says Jim Rowley, senior investment analyst at Vanguard Group, which manages $4.7 trillion in index fund assets. “The probability of capturing the return” of the stock market with index funds is “really high,” says Rowley.
The tradeoff, he adds, is that you’re giving up the “opportunity to potentially outperform” the market.
Low cost. Index funds charge low fees, which means more of investors’ dollars can be invested. Vanguard’s 500 Index Admiral fund, for example, has an expense ratio of 0.04% (4 basis points), which equates to $1.20 per year based on the fund’s $3,000 minimum investment. Charles Schwab offers S&P 500 index funds with an expense ratio of 0.02% and Fidelity Investments offers a few diversified index funds with zero expense ratios.
The math, says Vanguard’s Rowley, works in the favor of investors who pay lower expenses.
Fewer trading decisions. Instead of doing a lot of research to try to figure out what stocks to invest in to grow your wealth, index funds do all the work for you.
“It’s a one-decision investment,” says Tony Ogorek, president and founder of Ogorek Wealth Management. “Instead of trying to pick what companies are going to be the winners, just buy the index.”
Index funds allow you to dodge “company-specific” risk that can drag down a portfolio’s return, he adds.
For example, if you think pharmaceutical stocks are a good play right now, but you’re not sure which ones to buy, you can buy the entire sector via an index fund, Ogorek adds.
Ogorek also argues that owning a broad basket of funds could lead to fewer panic- or emotion-driven trading decisions, leading to better returns.
“The problem is most people look at stocks as a way to make money, but people look at index funds as a way to create wealth,” Ogorek says. “If you have an index fund, it diminishes the odds that you will fall in love with a stock, thereby removing some emotion from the investment equation.”
The main cons of investing in index funds is the inability to earn market-beating returns; being exposed to the worstperforming stocks in the index and names that, due to their market capitalization or share price which influence and index’s performance, can drag down index returns; and never having the thrill of owning a stock that shoots to the moon.
Pros of individual stocks
Potential to beat the market. Investing in an index fund simply helps you keep pace with the market. But investing in a successful company that creates new products that transform the way we live, such as Apple and the iPhone, or Facebook with its social network, or Amazon with its online shopping dominance, can make you wildly rich.
“There are some names that shoot the lights out, and they do great,” says Vanguard’s Rowley. The tradeoff? You also run the risk of owning stocks that implode and can damage your portfolio.
You control your own destiny. If you’re the type of person that likes to do your own research and make decisions on your own, researching and buying individual stocks could make sense.
But if you’re looking for that stock-picking experience, it’s best to just “dedicate a portion of your portfolio, maybe up to 10%” to individual stocks,” O’Shea says
The bottom line: Whether you go the index fund route or prefer to buy stocks on your own, “make sure you pick a strategy that’s not going to keep you up at night or cause you to panic sell at times like this,” O’Shea says.
Adam Shell