Picking Individual Stocks vs Buying an Index
“ You must force yourself to consider opposing arguments. Especially when they challenge your best-loved ideas.” — Charlie Munger
There are three main ways of investing in the stock market:
- Buying an index fund, where you essentially are buying a whole group of companies and other financial assets;
- Choosing individual companies to buy;
- Investing through funds that are actively managed by professional money managers, also called mutual funds.
There is no such thing as the best strategy that works for everyone. You should use the one that fits your goals.
In this article, I will focus on the first two strategies because investing in mutual funds usually involves paying high commissions, even when you have no profits on your investment. And many mutual funds can’t even “beat the market” so you would be better investing in an index fund with a low expense ratio.
Index Funds
If you buy an index fund, you become exposed to a broad basket of companies, that has both high quality, but also low-quality businesses. This strategy will get you average market returns, which in the long-term can be good. If you look at the S&P 500, for instance, it has an average annualized total return of around 10% over the last 90 years. The S&P 500 is a stock market index that measures the value of the 500 largest companies traded on U.S. stock markets.
At some point, you can think of this investing strategy to be less risky, because as you own a broad group of companies, if one goes bankrupt, it gets replaced in the index by another one.
Another possible advantage is that you don’t need to spend time studying and selecting individual stocks to buy.
Picking individual stocks
On the other hand, if you buy only a select group of great companies, you can get higher returns than those of merely purchasing an index fund. This strategy involves more effort because it requires a careful analysis of each company we buy.
We will be less diversified here, but we will have a better knowledge of what we are buying.
In contrast with the previous strategy where you can “buy and forget it”, picking individual stocks requires you to be actively investing (researching companies, buying at a discount to their fair value and sell when the price is way above the fair value).
Conclusion
In this article, I have presented two distinct ways of investing in the stock market. Both have advantages and disadvantages, and you should pick the one that best fits your goals and needs.
Most importantly, to get good returns on our investments, we should always have a long-term perspective!
Thanks for reading!
Originally published at https://vitorpedro.com on May 9, 2020.
This is not investment advice. It is only by humble opinion on the topic.
