If you’re like most Americans, then at some point, you’ve probably thought about investing your money. You probably started by asking yourself if it would be better to invest in individual stocks or an index fund. So, do index funds beat individual stocks?
In general, index funds beat 76% of individual stocks over 20 years. This is due to the lower costs of investing in these funds and their low volatility. On the contrary, only 26% of individual stocks tend to outperform passive funds in the long term.
So, are there drawbacks to investing in index funds, and what other investments can one consider? Read on as we discuss these and few other topics to help you make an informed investment decision!
IMPORTANT SIDENOTE: I surveyed 5000+ traders (and interviewed 50+ consistently profitable traders) to identify 7 statistically proven steps that will empower you to become a consistently profitable trader. Read my article: ‘7 Proven Steps To Profitable Trading’ for an in-depth assessment of data collected through this survey! – This is perhaps the most comprehensive and data backed article on becoming consistently profitable trader that you will find on the internet!
2 Reasons Index Funds Beat Individual Stocks
There are many reasons why index funds beat individual stocks, but the most important ones are:
- They have lower expense ratios.
- They are less volatile.
Let’s look at each of these in more detail:
Index Funds Have Lower Expense Ratios
Generally, index funds have very low expense ratios, as they charge very little in management fees.
When investors choose an index fund over an individual stock, most of their money goes toward purchasing shares of a large number of companies at once rather than paying for work by analysts and management teams whose primary goal is to turn profits and protect their interests.
Index Funds Are Less Volatile
Typically, index funds are less volatile because they are diversified. Index funds give investors instant access to an entire market or a large portion of the market, usually composed of many different companies and representing various sectors of the economy.
On the other hand, if you buy one stock and that company suffers some economic crisis, or if one big client ends their engagement, all of your money could potentially go down the drain.
This is less likely to happen to an index fund unless there’s a global financial crisis.
Here’s a video that explains how index funds work in more detail:
3 Drawbacks of Investing in Index Funds
Now that we know why index funds beat individual stocks, you might be wondering if there are any drawbacks to investing in an index fund.
There are three main drawbacks to investing in an index fund:
- Lower downside protection: Index funds aren’t guaranteed to go up in value, and they don’t offer the same kind of downside protection that you get from investing in individual stocks.
- Limited composition choices: You can’t choose which companies are included in the index fund, so there’s no opportunity for you to take advantage of your expertise.
- Limited exposure to different strategies: Index funds are passive investments, so there isn’t much opportunity for investors to try out different investment strategies. While you absolutely can get creative with your index fund investments, generally speaking – you would have much higher flexibility to execute different trading strategies with individual stocks.
Choose Between Index Funds and Individual Stocks Based on Your Risk Appetite
When it comes to choosing between investing your money in index funds or individual stocks, one thing you should consider is how much risk you can tolerate.
If you’re young and not focused on any specific goal, then perhaps the risk wouldn’t be as big of a deal. But if you are older or trying to save for retirement, then the risk will probably be something you will want to think about before making any investment decisions.
Individual stocks are often more volatile than index funds, especially when it comes to specific industries. So, instead of just choosing between investing in an index fund or individual stock, why not try allocating some money to both?
That would give you access to more opportunities while also giving you the security of knowing your assets are diversified.
For additional information on diversification and its advantages, I recommend reading Beyond Diversification from Amazon.com. The book explains the crucial factors to consider when spreading your investment in different assets to minimize exposure to risks while increasing the chances of earning better returns.
Other Alternatives to Invest Your Money Wisely
Now that you know why index funds beat individual stocks, maybe your next question is what other options are available for you to invest in.
Options are contracts that give investors the right to purchase or sell an underlying asset at a certain price. Contracts have specific expiration dates where they either become worthless or result in some action taking place. Let’s look at the two different types of options.
A call option is an agreement that gives investors the right to buy a specific stock at a set price within a specified time frame. This price is called the strike price.
Anytime before the expiration date, you can sell your contract. If the market value of the underlying asset is above the strike price, you can buy a call option with a high strike price and immediately sell it for a profit.
A put option gives investors the right to sell their stock at a price known as the strike price. Investors who own put options are only liable to lose the amount of money they paid for their put option contract.
A bond is a loan that an investor gives a company, government, or other organization in return for interest payments until they get their money back.
Let’s talk about the two main types of bonds.
These are issued by different kinds and levels of government:
- Federal governments
Typically, these sorts of bonds have lower interest rates because they’re less risky to invest in. These tend to be popular with people who want a secure investment that won’t lose value over time.
Companies issue these to get funding for a project or another business venture. They tend to offer higher interest rates because they’re riskier, but the investor will make a big profit on their investment if the company does well.
Commodities are raw materials and agricultural products that investors can trade on the market.
- Agricultural products: Coffee, Cocoa, Sugar
- Live animals: Cattle, poultry
- Mineral fuels: Coal, oil
- Precious metals: gold, silver
- Industrial metals: Steel, aluminum
- Fiber & Textile products: Cotton, wool
Note: These commodities’ prices are subject to supply and demand factors, so they can fluctuate rapidly. This makes it an attractive asset class for investors, especially those who want to diversify their portfolios.
Gold is another attractive asset class for investors because it’s not tied to any particular market or product cycle. And since demand is constantly increasing, the price of gold tends to rise. With that being said, buying physical gold can be expensive, so some prefer investing in companies that mine gold.
This is one of the most popular types of investments because it’s tangible, which means that you’ll always hold an asset that can be sold or rented out at any time. However, real estate is not risk-free since prices are subject to market cycles and interest rates.
On top of that, there are also a lot of expenses involved with owning real estate.
These include, among many others:
- Property taxes and repairs
Pro Tip: For the best results, I recommend splitting your investment across different asset classes. This minimizes risk exposure, improving the chances of getting higher returns in the long term.
3 Tips on Allocating Assets in Your Investment Portfolio
How you decide to split up your investments is entirely up to you.
However, there are some guidelines that can help ensure that your portfolio will be able to weather market fluctuations in the future. Let’s discuss them now.
Only Invest What You Can Afford to Lose
The rule of thumb is never to invest more than you could afford to lose without changing your lifestyle in any way.
This means you should only set aside an amount that would not disrupt your lifestyle should you lose all it. For example, you should still be able to pay the rent or mortgage each month and put food on the table, even when your investments go down to zero.
Diversify Your Investments
This means that you shouldn’t put all your eggs in one basket. Instead, you want to spread them out to reduce risk.
An easy way to do this is by investing in stocks, bonds, commodities, or real estate since they tend to fluctuate at different rates. However, avoid investing too much in any one type of asset since this will increase your risk.
Invest Early and Invest Often
This means that instead of keeping all of your money in cash until you can afford to start investing, it’s best to start putting small bits of money away each month. This will help you snowball your investments and grow them faster than if you only invest once or twice per year.
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In a nutshell, index funds outperform up to 76% of actively managed funds in the long term, so the odds favor investing in them. Because of that, they are a great investment choice for most people.
Index funds give you the diversification in the stock market at a price that is at least comparable, if not better, than the actively managed funds. They have lower fees, and can be more tax-efficient than some active strategies.
Finally, index funds also require less turnover in a portfolio, which results in fewer taxable events.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘7 Proven Steps To Profitable Trading’. I surveyed 5000+ traders (and interviewed 50+ consistently profitable traders) to identify 7 statistically proven steps that will help you become a consistently profitable trader. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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