Why The Average Investor Should Choose Index Funds Over Picking Individual Stocks

Index_funds_over_picking_individual_stocksWhen it comes to picking stocks for a portfolio, the average investor is at a big disadvantage.  Now I’m not talking about investing in mutual funds, which can have big ol’ expense ratios baked into them.  I’m talking about good ‘old fashioned stock picking’, where you research companies, pick out which ones you like and invest in them.  It doesn’t matter whether you invest through your retirement accounts or your personal investment portfolio, you’re still very unlikely to beat the returns of a diversified index fund.

I’ll be the first one to admit it’s not that sexy to be invested in Vanguard 500 Index Fund(VFINX).  In fact, it sounds a lot cooler to tell your friends you own shares in Apple, Google and Facebook(well maybe you don’t want facebook) as opposed to a boring index fund.  But there are some major drawbacks to picking out individual stocks that you may not realize.

Beating the Market

I had a friend at work come up to me and tell me how he’s “killin’ it” this year in his retirement portfolio, up 14%!  He rattled off a few blue chip companies and overall I thought he actually did a pretty good job of picking individual stocks.  There are much worse strategies that he could have employed.  But then I did a quick check on the YTD return of the S&P 500 and as of 11/6/12 it was 15.63% while the return of VFINX was 15.48%.  His return was over 1% less than the average return of the market and what he could have gotten with a low cost 500 index fund.

Personally, I don’t like to pick individual stocks because it’s not worth my time.  My returns need to not only achieve the market average, but also surpass them to make it worthwhile.  I know that I would be very thorough if I was going to pick stocks for my entire retirement portfolio.  But it would only take me 30 seconds to invest in a low cost diversified index fund, while a ‘stock picker’ might spend 10-20 hours or more researching companies, reading through prospectus’, etc.

Better Than the Pros

Let’s say you don’t mind staying up late after work and researching companies until the wee hours of the night.  Remember that when it comes to picking individual stocks, you’re competing against professionals.  There are people that do this for a living and they spend 40-50 hours a week researching companies, reviewing financials and studying transactions.  And the strange thing is even the professionals can’t consistently beat the market.

Do you know of any actively managed funds that have consistently beat the market over the past 10 years?  There might be a handful, but what about the past 20 years?  How about any active fund managers that tie their compensation to their fund’s performance, I sure don’t know of any.  Take a look at this interesting analysis by Daniel Solin that showed how the big three US investment banks under-performed their benchmark average 65% of the time.  That means that 65% of the time your fund was likely to return less than the market average.

Is it Ever ok to Pick Stocks?

Now that you know the proper benchmark to measure your returns against, what if you are successful at picking stocks?  As I mentioned earlier, there are much worse strategies you could use than picking 5 solid blue chip companies.  But with this blue chip strategy, your returns will most likely be close to the market’s average return.  You’ll be very unlikely to exceed the benchmark by investing in safe companies because drastic and surprising growth is not likely to happen.  If you are seeking above average returns, you have to be willing to take on above average risk and invest in up and coming companies that will exceed their projected growth.

I was actually lucky to start investing in a bear market because I had a relatively small amount of money and I lost most of it very quickly.  It taught me a valuable lesson about picking individual stocks and today individual stocks make up only 5% of my total portfolio.  I consider this portion more akin to gambling though and to constantly remind me how tough it is to pick winners.

Although online investment brokers have made it very inexpensive to invest in individual stocks, I still don’t think the risk-reward is worth it.  Companies like Schwab and Vanguard are lowering their expense ratios all the time on their index funds to compete with one other.  Unless someone is willing to share with me their guaranteed strategy for picking winners that will beat the average market returns I’ll probably stick with my boring index funds.

Readers, what percentage of your portfolio do you invest in individual stocks?  Is there some added benefit to this strategy that I’m missing or do you just like to be in control of the funds you own?

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-Harry @ PF Pro

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Hi, I'm Harry, the owner and head writer for Your PF Pro. I started this site back in 2011 in order to create a place where young professionals could come and get all of their financial questions answered. On the site, you'll find articles on everything from asset allocation for retirement to saving money at Chipotle! So enjoy..

Comments

  1. says

    totally agree. I have never invested in anything other than index. I had one average the European market, one US, one Asia-Pacific and one UK. Now I sold them to buy some land but would repeat when I have some cash. If some managed fund don’t beat the market, chances are I won’t either.

    • says

      It’s not just some managed funds that don’t beat the market, it’s almost all of them(over extended periods of time). I think it’s funny too that people will pick big blue chip stocks when they do pick stocks since these are the safest and very like to return somewhere near the average market return.

  2. says

    I’m with you, Harry. There is absolutely no thrill to me in picking stocks. I find that index funds give me more control since they allow me to focus on how much I’m saving rather than what I’m saving my money in.

    My employer matching in my 401(k) goes into their stock, but I do at various intervals move it into the S&P 500 index fund instead.

    I take zero interest in researching stocks. I’d far rather spend my time organizing my money and projecting how much money I’ll have saved in X months/years than researching stocks or how much sooner I’ll have paid off my mortgage if X happens.

    • says

      Great points Leigh. Especially at a young age, rate of savings is so much more important than what you invest in.

      That’s definitely a smart move to get out of your company stock at various intervals of time. See Enron

  3. says

    Good post Harry. I would totally agree that for most retail investors thst being heavily in index funds is the best and simplest thing to do. Many just don’t have the needed knowledge or time to stay on top of the investments. I love doing research, just ask my wife it can drive her nuts, but there’s only so much of it you can do and at the end of the day you just can’t compete against the big boys. I tend to be about 50/50 on a mix of individual stocks and index funds. It ebbs and flows at times, but that is the general mix I tend to stick to.

    • says

      Thanks John, out of curiosity, do you own a wide array of individual stocks or just a few that you feel confident in? I just feel like even the “big boys” can’t beat the average return, so how could I? haha

      I would be curious to see how their returns would stack up though without fees. Maybe then, there would be some who could consistently beat the market and that would give the rest of us some hope.

  4. Bichon Frise says

    “As I mentioned earlier, there are much worse strategies you could use than picking 5 solid blue chip companies. But with this blue chip strategy, your returns will most likely be close to the market’s average return.”

    I think this needs a big huge asterisk. 5 “solid” blue chips will almost always do worse than an index fund over the long run. The reason is unsystematic risk. You are not compensated well for taking this risk on b/c it can “easily” be done away with.

    So, if you are to hold the 25 or so “different” stocks it takes to do away with unsystematic risk, you’ll start to see how fees eat away at people with small portfolios. Which is even more reason for a “younger” and most likely a “poor” person who will get taken to town in fees and transaction costs. A small percentage of the population has the investable assets to over come the burden of the transaction costs of a portfolio to overcome unsystematic risk. Not to mention the burden of time.

    And we’ve come full circle, back to the index fund.

    “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” -Warren Buffet, ’96 Annual report (link on my blug)

    • says

      BF, that’s a good point which I tried to allude to unsuccessfully :) Even if you could invest in 25 companies for free, there’s no reason to. That’s what an index fund does!

      I don’t think investing in 5 blue chippers is a good strategy but I do think it’s better than something like investing in company stock, which you would be amazed how many people at my company do. Again, ENRON! haha

      Just for fun, I made a quick spreadsheet though to see how the top 5 holdings and top 6-10 holdings in VFINX fared against VFINX YTD and over the past 5 years. Interesting results. I wonder what these results would be like over a 10, 20 year period..

      https://docs.google.com/spreadsheet/ccc?key=0AlCrDpin7ZfadHZ5UmllWUpwQm1SRUFueUdxbVVrN2c

  5. says

    We’ve only got about $600 in individual stocks. The rest are all mutual funds or ETFs. Our mental energy was much better spent over the past few years understanding and investing in RE than it would have been in stocks. Maybe eventually we’ll pick more individual stocks, but for now ETFs and mutual funds suit us very well.

    • says

      Everyone is entitled to their own opinion, but I’m curious what losers you’re referring to? If you pick any low cost index fund from any major broker your will return very close to the market. Now the market’s returns can be dismal at times, but people invest in the stock market because they believe in an efficient market. Average return is 10% since it’s inception.

      What strategy do you recommend for the average investor?

    • says

      MOA, thanks for stopping by. Buy and hold is the same thing as buying and never selling so I’m a little confused by your strategy suggestion.

      I wrote an article on dividend investing for young investors where I explained why I don’t think it makes sense. For older investors, dividend investing is not a bad idea, but I would probably use an index fund over picking companies in this situation too for the reasons Bichon Frise mentioned above.

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