New investors often struggle with figuring out where to invest their money. The two most common recommendations they will hear online are to invest in index funds or individual stocks. If you’re like most people, you probably don’t know the difference between them.
Never invest in anything unless you understand what it is first. Index funds and individual stocks can be lucrative investment opportunities if you know what they are and how they can make you money. It all depends on your investment goals and the amount you want to invest.
Let’s review the general differences between index funds versus individual stocks and the benefits and risks of investing in each.
Index Funds
An index fund is a type of mutual fund or exchange-traded fund that invests in securities that replicate the composition of a particular market index, such as the NASDAQ, Dow Jones, or S&P 500.
For example, if you invest in the Vanguard 500 Index Fund, you invest in the 500 largest companies in the United States. It is an index fund that invests in stocks listed in the S&P 500 index, which means investing in the index fund is essentially the same as investing in the S&P 500 listed companies.
Benefits
Here are the primary benefits of investing in index funds.
1. Diversified Investments
Index funds allow investors to make diversified investments. Rather than investing a lot of money in individual stocks, you can invest your money in an index fund comprised of many different stocks. That way, if one of the stocks fails and loses profits, it won’t significantly impact the value of the overall index fund.
2. Less Risk More Reward
Index funds are generally safer investments because their diversification makes them less volatile than individual stocks. You will feel more comfortable investing large sums of money in index funds because they are less likely to plummet in value due to the various high-value securities they hold.
3. Great for Beginners
Index funds are a great investment choice for beginners with little investment experience. You don’t need to do much investment research or strategizing regarding index funds because they offer a consistent performance with steady, long-term gains.
Risks
Here are the risks of investing in index funds.
1. Slow Gains
If you hold onto your investment long enough, index funds will eventually make you a sizeable profit. However, some investors won’t like the slow trending growth of index funds and might prefer other types of investments with more volatility and the potential for faster gains.
2. No Control
Investors don’t have any power or control over the stocks held in the index fund because it only matches the index performance. Major investors might not like the lack of power they get from investing big in an index fund.
3. Susceptible to a Bad Economy and Recession
Index funds generally don’t lose value during any normal economic conditions. Unfortunately, they can still suffer the consequences of a lousy economy or recession like any individual stock. Since hard financial times will plummet most stock prices, most stocks held within the index funds will plummet. Once that happens, the index fund will plummet along with them.
Individual Stocks
Individual stocks represent shares of ownership in a company that are traded on a stock exchange, such as the NYSE or NASDAQ. Every publicly traded company allows investors to purchase shares of ownership. Investors hope the company will become more profitable and do well because that will raise the value of the stocks, giving investors more equity value in their shares.
Benefits
Here are the benefits of investing in individual stocks.
1. Potentially Faster Return on Investment
Individual stocks are more volatile than index funds. However, they can offer investors significantly higher returns based on each company’s success and profitability.
For example, Apple and Amazon stock values have risen quickly over the last decade due to the enormous successes of those companies. If you had invested $1,000 in Amazon a decade ago, it would be worth over $10,000 today. That kind of growth is not usually seen in index funds.
2. Full Control Over Investments
Investing in individual stocks gives you complete control over how many shares you buy and sell of a particular company. You don’t have to rely on index fund managers to make those decisions, which you might not often agree with. You can create effective investment strategies for maximizing your returns based on your preferences and objectives.
3. Dividends
Many large publicly traded companies will pay dividends to investors who own company shares. Most companies pay a quarterly dividend for each share owned, such as $0.50 or $1.25 per share every three months.
For instance, if you owned 100 shares in a company paying a dividend of $1.25 per share each quarter, you would be paid $125 in dividends every three months. You can even have your online broker automatically reinvest those dividends into the company to increase your share count and potential to grow your portfolio.
Risks
Here are the risks of investing in individual stocks.
1. Higher Risk of Losing Money
The high volatility of individual stocks makes them much riskier investments than index funds. You have a much higher risk of losing money in individual stocks if you don’t have a concrete investment strategy.
For example, if you invest thousands of dollars in one company’s stock and it does poorly, you will lose most of the money invested. That wouldn’t happen with an index fund because one company’s failure won’t plummet an entire fund comprised of hundreds of different companies.
2. More Research Required
Individual stocks are more suited for experienced investors who know how to perform the additional research required before investing in particular companies. Even if you invest in a popular company like Amazon or eBay, you must do the necessary research to determine the company’s current financial health. You might find that even a big company might be trending in the wrong direction regarding sales and popularity.
Conclusion
Investing in index funds and individual stocks has its ups and downs. Index funds are safer investments for investors who prefer peace of mind and long-term growth. Individual stocks are better for investors seeking gains faster while taking on more risk and volatility.
Start with index funds if you are new to investing. Then, as you gain more experience, you can gradually venture into making individual stock investments once you feel confident as an investor.
