Good investing is all about making good choices, and one of the first crossroads you’ll come to as an investor is choosing between individual stocks or index funds. In some scenarios, this decision will be made for you, like investing in a 401(k) account. But suppose you’re choosing assets for an IRA or taxable brokerage account and forgoing a financial advisor. In that case, you’ll need to decide what combination of stocks and index funds to hold.
In this article, we’ll explain how stocks and index funds work and why you might consider investing in either asset. You’ll learn the benefits and drawbacks of adding stocks and index funds to your portfolio and how to form a preliminary assessment of your risk tolerance to determine the best asset balance.
Individual Stocks
When you buy stocks in your brokerage account, you’re buying a small piece of a publicly traded company and entitling yourself to a portion of that firm’s profits. Think of public companies as puzzles with millions of different pieces. Most pieces are held by the company’s executives, employees, and large institutions. However, anyone with a brokerage account (and enough capital to buy a share) can invest in one of these pieces.
For example, if you wanted to invest in the tech sector’s hottest trends, you might look at companies benefiting from the artificial intelligence boom, such as NVIDIA Corp. (NASDAQ: NVDA) and Advanced Micro Devices Inc. (NASDAQ: AMD). You can purchase shares of either company in your brokerage account, and if these firms report high profits, the value of the shares (and, therefore, your investment) will go up.
Benefits of Individual Stocks
Many books have been written about the fortunes earned from individual stock investments. And while not everyone can be early to the next NVIDIA, you can still improve your financial future with stocks. Here are four primary benefits of individual stock investing:
- Potential for Higher Returns - If you were an early investor in companies like NVIDIA or Amazon Inc. (NASDAQ: AMZN) and stayed the course over decades, you’re likely sitting on life-changing wealth. Individual stocks can be volatile, but if you find a generational company and remain invested, you could be looking forward to an early retirement.
- Voting Rights - Shareholders earn more than money from their stock; they also have a say in company decisions, such as electing board members or raising more capital.
- Dividends - Stock price appreciation isn’t the only way to profit from owning individual companies. Many firms return earnings to shareholders through quarterly dividends, which are paid out regularly and can provide consistently steady income.
- Customization - Investing in individual stocks allows you to build a personalized portfolio with as many (or as few) shares as you want. Index funds track a benchmark like the S&P 500, which means your portfolio construction is outsourced to fund managers or index constructors.
Drawbacks of Individual Stocks
Investing in individual stocks also comes with risks and negative consequences if you don’t know what you’re doing. In contrast with the list above, here are four cons of personalized stock picking.
- Higher Risk Than Index Funds - Index funds are diversified and less volatile than individual stocks, which makes them more appealing to risk-averse investors. The fewer stocks in your portfolio, the more you can expect to endure heavy drawdowns and volatility.
- Firm-specific Risks - Individual stocks also carry risks unique to the underlying company. For example, an index investor doesn’t need to worry much about CEO impropriety or an earnings miss since they own many companies in a single security. However, individual stock investors must be aware of any company-specific risk when buying shares.
- Time-consuming Research - Investors buying individual stocks choose from thousands of companies in various sectors and industries. Picking the proper stocks requires due diligence, which means listening to conference calls, reading analyst reports, and scouring financial documents while monitoring broader economic and geopolitical trends. Sounds like fun, doesn’t it?
- May Still Fail to Beat Benchmarks - Even after hours of meticulous research and precise stock selection, your investment portfolio could still lag the index. For many investors, there are simply too few hours in the day to monitor and update stock investments constantly.
Index Funds
Making an index fund is a bit like making an omelet. Some people want something simple like a cheese omelet, while others prefer heartier ingredients like a Western or Mexican omelet. Despite the different ingredients, they’re all omelets. Index funds are composed similarly - the ingredients may differ, but the basic recipe is the same.
Each index fund tracks a benchmark, such as the S&P 500 or the NASDAQ 100. Different indices follow stocks of various sizes and industries, but benchmark tracking is the fundamental similarity. No fund manager is trying to find the winners and eliminate losers; the fund simply tracks the underlying index by matching components.
Benefits of an Index Fund
Many of the mutual and exchange-traded funds (ETFs) in our IRAs and 401(k) accounts are index funds, and for good reason. Here are four key benefits of index investing:
- Instant Diversification - An index fund comprises all the stocks in the underlying benchmark. So, if you own a NASDAQ 100 index fund, you’ll own all 100 stocks in that particular index. Owning 100 (or more) stocks through a single security means you can instantly build a diversified portfolio.
- Cheaper than Active Funds - Actively managed funds have higher turnover and expenses, which can eat into investment returns (or anger investors if the fund underperforms). Index funds often carry expense ratios as low as 3 basis points.
- Set-It-and-Forget-It - Index funds are often the preferred vehicle of retirement savers because broad-based funds can be held for decades with minimal turnover. For many savers, worry-free retirement investing is better than a few points of outperformance.
- Simple and Efficient - With limited intervention, anyone can purchase index funds and expect them to perform reasonably well over long periods. Index funds' simple approach makes them appealing to novice and expert investors.
Drawbacks of an Index Fund
Index funds are simple and less risky, but that doesn’t mean they’re foolproof investments. Here are some critical downsides of index investing to remember when building your portfolio.
- Potential Underperformance - Index funds track a benchmark, nothing more. That hot stock outperforming the market? You’ll only own it in equal proportion to its benchmark weighing. If you dream about getting wealthy from well-research stock investments, index funds might leave you wanting more.
- Limited Selection - Although you’ll find a wide range of index funds, you’ll still be bound to their asset allocation and investment thesis. If you want to increase your weight in winners like NVDA or AMZN, you’ll want to buy the individual shares yourself.
- Tax Implications - Finally, index funds buy and sell assets to keep up with their benchmarks, which means stocks are bought and sold regularly. This can create tax complications if you receive a capital gains distribution you didn’t anticipate. Consider tax implications when buying index funds in taxable accounts (and use our tax calculator tool)
How Individual Stocks and Index Funds Differ
Index funds are made up of individual stocks, but that doesn’t mean the two assets share similarities. You’ll be subject to market risk and taxation with either vehicle, and you’ll need to understand your personal risk tolerance and investment plan before choosing either.
While they share specific characteristics, individual stocks are riskier than index funds since they have the potential for significant underperformance or irreversible capital loss. When investing in index funds, you protect yourself from the bankruptcy risk of an individual company. But if you invest in only a handful of stocks and one goes belly up, your portfolio could take a severe hit while the rest of the market chugs along unscathed.
How to Choose Which Is Right for You
Investment portfolios aren’t one-size-fits-all. Here are a few factors to consider when constructing your asset base:
- Time Horizon - How long do you plan on staying in the market? The time you keep your capital invested significantly influences returns in both types of securities, and people with long time horizons often have stronger stomachs for risk.
- Investment Goal - Are you investing for retirement or a first-time home purchase? Or are you simply trying to make as much money as possible with your free spending cash? The purpose of your investment helps inform your asset allocation, so consider your goals before building a portfolio.
- Risk Tolerance - Time horizon and risk tolerance are often related, but personal risk should be assessed when choosing assets. Can you tolerate volatility? If you have a concentrated stock portfolio, could you stick to the plan if your holdings lose 15% in a week? Indexing might be the best path if you’re prone to emotional buy or sell decisions.
Choosing Between Individual Stocks and Index Funds Requires Proper Risk Assessment
Buying a few shares of NVDA in your Robinhood account might be an exciting way to get individual stock exposure, but building a portfolio of individual stocks is an entirely different animal. Be sure to consult with a financial advisor before putting significant capital into individual stocks or index funds, and always understand your time horizon and goals.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
