Why Use Index Funds vs Individual Stocks

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“Did you buy Apple?” “I made a killing on my weed stocks.” “Facebook went up 3 times the price that I bought at.” Those are all common phrases that I come across all the time. It’s not uncommon for regular investors to hit it big on stocks where they put a few thousand dollars in and come out with a hundred thousand. Since gains in individual stocks can be so rewarding, why do I always preach to use index funds to invest in the stock market? Am I preventing people from getting financially independent faster?

It’s not a lie that buying individual stocks can offer bigger gains. When I talk to people and tell them of investing for the long term, people always give me a disappointing look. “I want to get rich now like Mark Zuckerberg? He’s made billions before 30 and I’m still stuck at a 9-5 making $25 dollars an hour.” We all can’t be Mark Zuckerberg, there are people out there with special talents and the right idea at the right time. Additionally, these billionaires invested in themselves and are majority owners of their publicly traded company. As investors, we’re not as privileged to own large percentages in these companies because we’re not founders. It’s totally different, as founders there is much more at stake and greater risks were taken. As shareholders, we’re looking for a piece of the pie.

All Time Great

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People talk about how much they’ve made on Apple, or how much money they’ve made on weed stocks, but the greatest stock picker of all time, Peter Lynch, was only able to sustain 29.2% annual return over a period of 13 years. During that period there was one significant stock market crash in 1987.

Now if the best stock picker ever only averaged 29.2% over a decade, what are the chances that a non-professional financial expert have at beating that? What makes us so sure that our trading abilities are sufficient enough to beat the annual return of the stock market as a whole? In all likelihood, none of us have experienced a large market crash, because the stock market has performed so well since the last crash in 2008. That’s almost a decade of forever rising stock markets. It’s not hard to pick a winner when everything is always rising, but what happens when stocks fall? Can we avoid losing our shirt?

Less Funds, Higher Risk

How many people do you know that invest in individual stocks and have made great gains have actually invested all of their assets? Would that person take enough risk to have put their life savings on the line when buying just Apple stocks or bet their bank on weed stocks? Probably not.

While an individual stock picker may say that she’s tripled her investment or made 10 times her original investment, it’s hard to make the argument that they actually did well. That’s because she probably invested a small portion of her savings into that stock. So if she had $50,0000 in cash and invested 10% of it into Apple, and it spiked up 10 fold over 7 years, she would have $95,000. Other the otherhand, someone with a passive investment portfolio that utilized the entire $50,000 over that same 7 year period could have experienced a doubling of their investment portfolio. So someone who did the slow and steady approach could be at $100,000, whereas the all-star stock picker only has $95,000.

The risk associated with buying one stock is much greater than buying index funds. That’s because when you put all your eggs in one basket, that one stock can wipe out your entire life savings. Logically, most investors will not have the courage to put their entire life savings into one stock because the risk is too high. They’ll dabble a little here and a little there because it’s “fun”. It’s also a great story to tell your friends when your $100 becomes $2000, but ultimately the gains are negligible because there is so much more opportunity that was lost by not utilizing all available funds.

You Only Hear The Good News

Every investor that goes their own route will always tell the good story. “I made a killing on Apple.” “Facebook made me rich.” When talking about losses it’s always someone else’s fault. “Nortel lied about their accounting”. “The markets are manipulated.” An active investor will never take fault in their bad choices. That’s because it’s embarrassing to talk about losing $20,000 on a random stock pick. No one wants to look inferior to their friends or companions.

The fact is, the best professional stock picker has only been able to average 29.2% with a stock market crash happening in the middle. It’s highly unlikely an inexperienced investor with no experience is able to replicate that same success. Highly unlikely. An investor may get lucky on her first pick, but it’s extremely difficult to continual to have success picking the right stock with little experience. Most of us are better off spinning the roulette wheel or randomly throwing darts at companies than picking the right stock to invest in.

That’s why for every good news you might here from a stock trader, there will be many bad ones that happen along the way that you will never be aware of. So when someone says they’ve made 10 fold or quadrupled their investment, how much has that affected their entire net worth? Have they actually lost money on other investments? $50,000 gained here but $30,000 in losses over there really only means that the stock picker is up $20,000 in total. It’s great to talk about the gains, but that may be distorting from the real truth.

Time Is Everything

With passive index investing, it’s possible to set it and forget it. That’s very low maintenance and very little overhead time required to invest a large sum of money. When picking stocks individually, it takes a lot of research in order to find a good stock to buy. In fact, most investors might be sitting on a lot of cash because they haven’t found something they find worthwhile investing in. This can be a huge opportunity cost. Remember that missing just a few good days in the market can be the difference between a good investment and a bad one.

By trading many stocks, it also takes exponentially longer to keep track of everything. how well are those companies doing? Are they still performing to expectations? Will those companies continue to grow? As people with day jobs, this is a lot to think about on top of our regular 9 to 5 jobs. Unless one was to quit their job and become a permanent day trader, it’s impossible to keep up with the changing markets. Using index investing eliminates all of this unnecessary work because it’s buying the entire market. There’s no need to do anything with the index investing strategy other than re-balance at the end of the year.

In the time necessary to finish this blog post, you might be able to rebalance or buy a balanced investment portfolio. Unfortunate, for a stock picker, she might not even know what stock she’s interested in buying. So unless taking the time, the risk and the know how sounds intriguing, it’s probably much more advantageous for the average investor to go with index funds rather than individual stocks.

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One thought on “Why Use Index Funds vs Individual Stocks

  1. Pingback: Lessons Learned | Financially Yours

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