Should You Invest in Individual Stocks, or Stick with Index & Mutual Funds?

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Should You Invest in Individual Stocks? Or Stick with Index & Mutual Funds?
In recent years there’s been a major push in the investment universe toward investing in funds rather than investing in individual stocks. This includes both mutual funds and exchange traded funds (ETFs). It’s hard to know how widespread individual stock ownership is anymore, but the typical investor, particularly small investors, is clearly gravitating toward funds.…

In recent years there’s been a major push in the investment universe toward investing in funds rather than investing in individual stocks. This includes both mutual funds and exchange traded funds (ETFs). It’s hard to know how widespread individual stock ownership is anymore, but the typical investor, particularly small investors, is clearly gravitating toward funds.

If you’re one of the growing class of fund-only investors, are you potentially missing out on some lucrative returns?

Should You Invest in Individual Stocks? Or Stick with Index & Mutual Funds?

Mutual Funds and Exchange Traded Funds (ETFs) Are Now the Investment Mainstay

Mutual funds and ETFs are essentially portfolios of stocks and bonds. They may include just a few securities in a very specialized sector, or hundreds in more general categories, such as the S&P 500.

There are tremendous advantages to investing in funds. One is professional management. A fund is managed by an investment professional, who manages the entire stock portfolio. That means that you don’t have to get involved in the day-to-day minutia of having to construct the portfolio, buy and sell individual securities, or rebalance the investment allocation as needed. You simply invest your money and turn the management over to someone who does it on a full-time basis.

There’s also the diversification aspect. By investing in the fund, you can spread your money across dozens or hundreds of individual securities with an investment of just a few thousand dollars. That’s a level of diversification that you could never achieve if you try to construct your own do-it-yourself portfolio.

And finally there’s the cost factor. By investing through a fund, you’ll avoid having to pay commissions on a large number of stock transactions. There may or may not be a single commission involved in the purchase of the fund, but it will be a lot less than the collective costs of commissions on buying multiple stocks.

You can improve the cost factor considerably by investing in no-load funds, or in index funds that have very low expense ratios. And typically if you hold funds through a fund family, there are no commissions or loads at all.

The entire fund concept is hard to beat, especially for small investors.

The Benefits of Individual Stocks

If funds are so great, is there ever any reason to invest in individual stocks? That’s actually a mixed bag, since it depends on a number of factors. One is your own personal skill level in choosing investments.

Some people develop the skill, and spent a lifetime trading individual stocks. Some even get incredibly wealthy as a result. But should you give it a try if you’ve never done it before? There are some advantages.

When you invest in individual stocks and pick the right ones, you can earn returns that are dramatically higher than what you can get with most funds. Fund diversification actually limits gains, at the same time that it minimizes losses.

You may have to be content to earn say, 7% to 10% in annual returns with funds. But an individual stock can literally double or triple in a year. Some stocks rise many times over, over the course of several years. That’s not typical, but you only need a few of those each year to improve your portfolio performance.

It also makes sense to invest in individual stocks if you have a strong knowledge of a particular industry. For example, if you work in the IT field and have a solid handle on the big picture of the industry, you might have real potential to earn high returns in the IT sector.

But even beyond being a trader, if you have the insight and the patience to buy and hold stocks of well-established companies, the kind that pay above-average dividends and show long-term growth patterns, you can outperform the general market over the long-term.

The Risks of Investing in Individual Stocks

Despite the advantages of investing in individual stocks, there are significant risks. That’s the whole reason why so many experts recommend fund investing for small investors.

Here are some of those risks:

You may not have the skill level necessary. It’s a fact that most fund managers often under-perform the general market. If that’s the case for professional investment managers, what chance do individuals have? The reality is that most people don’t have that ability, and are more likely to sustain large losses than large gains.

Bad calls. Just as it only takes a few winning stocks to pull up an entire portfolio, it only takes a few to produce large losses. Sometimes even if you know what’s going on with a company, you can still be blindsided by unexpected events. For example, I once purchased a stock that was recommended by Money Magazine, at $20 a share. A few months later it was a penny stock. I don’t remember the circumstances, but it happens in the real world.

Lack of adequate diversification. True diversification is more complicated than most people understand. It’s not just creating a portfolio of multiple stocks. You have to make sure that your money is spread across various sectors, and unrelated asset classes. That means investing beyond stocks, including allocations in other investments, such as bonds, real estate investment trusts, or even commodities. It’s possible that you know a lot about a particular industry sector, but a lot less about other sectors, let alone other asset classes.

A stock market crash. We’ve had two of these since 2000, so it’s something that has to be considered. This is also the whole purpose of adequate diversification. If you are invested too heavily in one or two stock sectors that seem to be successful, these may get hit harder in a crash than the general market.

Bad timing skills. We just discussed market crashes, and this is where timing plays an especially vital role. It’s very easy to get emotional about investing, since it involves your money. But that also means that you can buy too heavily at market tops, and then panic sell at the bottom of a crash. Both have the potential to create very large and long-term losses.

These risks are what keep a lot of small investors from wandering into individual stocks.

Do Individual Stocks Have a Place in Your Investment Portfolio?

None of this is to suggest that individuals stocks shouldn’t have a place in your investment portfolio. But if you are a new or small investor, it’s clear that the vast majority of your money should be invested in funds. That will enable most of your portfolio to at least keep up with the general market.

If you have an interest in a certain market, or in certain companies, you may want to consider holding a few individual stocks in your portfolio, along with those funds.

If the stocks that you purchase represent companies that have proven long-term track records of growth, and a consistent record of paying out dividends, they may provide an opportunity for you to increase your overall portfolio return.

Just don’t get carried away! There’s a Wall Street saying, little pigs become fat pigs, and fat pigs get slaughtered. So tread lightly with individual stocks, until you yourself have a track record and the confidence to wade in a little bit deeper.

For more information on how to start investing, check out our primer for new investors.

Do you keep a lot of individual stocks in your portfolio, or do you prefer to go with funds?

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About Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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