What are the pros and cons of investing in index funds vs stocks? I’ll share my worst investing mistake and we’ll discuss how choosing either could affect your path to financial independence.
I tried my hand at picking individual stocks when I was younger.
At 22 years old, I read money magazines about investing in individual stocks, commodities, and precious metals.
Occasionally, I purchased shares in company stocks I thought stood a good chance to rise in the future.
Evaluating the risk of putting my money into individual stocks vs index funds—which own tiny slices of lots of companies—wasn’t even on my radar.
I was severely lacking in investing knowledge, I couldn’t have answered:
- How do index funds work, what are they based upon?
- What are the differences between ETFs and mutual funds?
- What are the advantages of buying an ETF vs stock?
- How can index funds offer risk reduction through diversification?
After all, you can’t be better than average and capture that sweet alpha if you just buy the “average”—which is an index fund by its very nature!
Do you have a guess for what that did to my personal finances?
Read on to witness the destruction of half my net worth and learn all about these mysterious financial instruments!
- Experiencing a Stock Market Collapse
- Should You Invest in Index Funds or Stocks?
- Emotional effects of stock market losses
- Reducing risk with diversification
- Index Funds: ETFs or Mutual Funds
- Stock picking vs index funds
- Passive vs. active investing
- Risk-adjusted stock return
- Individual stocks vs index funds summary
- Index funds vs stocks FAQ
- My Most Expensive Mistake
Experiencing a Stock Market Collapse
I freaked out as half my life savings disappeared through late 2008 and into 2009.
My individual stocks underperformed the market.
Initially, these were just paper losses since I hadn’t sold my shares.
I’d returned from my stint in the Peace Corps to discover a dwindling net worth. I was in my mid-twenties and my nest egg wasn’t exactly huge, but it was all I had.
Initially, I held strong but the world was sounding the alarm.
Headline companies were going bankrupt.
Capitalism was dead!
This time it was different.
I wasn’t taking risks with my investments that are the good kind—that’s when you understand the type of fear that creates the risk and can mitigate it. Rather, my fear came from uncertainty that I simply wasn’t comfortable with during a huge stock market downturn.
The constant dread got to me, and I sold.
I sold it all.
The end of capitalism and the markets
I took a capital loss of more than half my total investments. I moved the money into safer investment: treasuries, money market funds, savings.
Hell, I even put some money into leveraged inverse S&P500 tracking ETFs.
Oh, not familiar with that type of ETF?
I’m not surprised, as leveraged funds are one of the riskiest types of investments. These ETFs carry significant expenses to leverage or multiply with debt, the change in the index they track. In my case, if the S&P500 went down 5%, I’d earn 15% (minus some leverage expense). If it went up 5%, I’d be down 15% (plus some leverage expense).
I’d really not learned my lesson it seems.
Fortunately, I’d already lost most of my investment so as the market recovered and my risky bet cratered, I only lost a little more.
Of the $34,015 I’d squirreled away and gambled over 2007, and some of 2008, I had less than half my net worth in 2009. Of the balance, I withdrew $3,300 in early 2009 to put into savings—nearly nailing the market bottom of the Great Recession.
I pulled another $3,617 out in May of 2010 as the recovery took a small stumble.
I didn’t make serious investments again until late 2010, missing out on a large amount of the recovery. The S&P 500 had bottomed at about 666 points near Spring 2009. By the beginning of 2011, it’d already nearly doubled. A similar whipsaw had occurred with the individual stocks I’d owned, with both the trough and peaks more extreme due to the volatility in the individual stocks.
I lost half my net worth picking stocks
This was the moment I realized that maybe I wasn’t smarter than the average investor. Just like when we grow up thinking we’re physically invincible, we often think—and are reinforced with praise—that we’re above-average at many intellectual pursuits. It’s funny that a group that prides itself on math (personal finance generally), often has so much trouble identifying the mathematical likelihood that we’re a coinflip from being above average.
A FIRE writer I respect, Dave, happened to write about his worst money mistake recently. I’m lucky my worst mistake didn’t lead me down a darker path.
To give you an idea of just how financially damaging the loss was during this time, here’s my Social Security Earnings history (by the way, you can obtain this official record from my Social Security if you’re in the U.S., we published our earnings history from 2006-2018):
The decision to sell in 2009 had turned a paper loss into a realized loss more than my entire earnings for the year.
The graph below reveals our net worth, including the 2008-2009 period, up until we reached financial independence in 2018. We turned things around after my episode learning about stocks and index funds.
Read on to find out what I learned and we changed in our investment strategy to send us the other direction and become millionaires in 10 years.
Should You Invest in Index Funds or Stocks?
As we’ve come out of another V-shaped dive in the stock market, I didn’t actually think much about our investments. If anything, I was trying to find some more money to invest with when things were looking grim—partly by rebalancing our portfolio.
Rather than being fearful, I was greedy.
But is this simply because I’m older now? Is it because of that previous mistake in the Great Recession?
What can you learn about investing in index funds vs stocks from my experience?
Emotional effects of stock market losses
Our paper losses during this recent market dive brought on by the pandemic equaled hundreds of thousands of dollars. Still, neither Jenni nor I really thought much about selling. I don’t think that’s because we’re “more experienced”, now.
I think it’s because we don’t own many individual stocks anymore. We’ve got a few shares from legacy accounts, but the vast majority of our wealth is tied up in index funds.
During the Great Recession, several individual companies were going bankrupt—Lehman Brothers, AIG, Fannie & Freddie—I remember General Motors going under chapter eleven bankruptcy!
Seeing those big names going under left me to think that maybe my carefully handpicked stocks could also be bankrupt. After all, the one thing that enough time for stock values to recover won’t solve is an actual bankruptcy event.
At the time, I was fearful that one of my individual stocks would go to zero.
Reducing risk with diversification
The key difference in buying individual stocks vs a broad index fund like VTSAX for me is that I’m pinning my hopes on the entire US market instead of an individual stock.
Vanguard Total Stock Market Index Fund (VTSAX) is a well-known mutual fund that attempts to track the entire US stock market. It operates with incredibly low fees and has a very similar sister ETF with the tracker VTI. When comparing VTSAX vs VTI, the key difference is in the minimum investment amount (higher with VTSAX).
If VTSAX goes to zero, we’re all probably screwed anyway.
That’d mean capitalism in the U.S. has truly collapsed.
It really helps me sleep at night to know that the chance of our index fund investments going to zero is so much less likely even if there’s a huge hit to the economy like during a pandemic.
The world will eventually recover and so too will the broad market alongside your index funds.
Individual stocks and the companies they represent have a much higher chance of seeing bankruptcy during a bear market. Shareholders are often wiped out. Unless the industry or country your index fund represents collapses, it’s not going to zero.
Index Funds: ETFs or Mutual Funds
A learning moment: index funds aren’t a specific type of investment that you can actually purchase (like a stock or bond).
We talked about ETF vs stock before, and index funds can be an ETF like VTI which tracks the total US stock market. ETFs, if you recall, are traded like stock shares.
However, index funds can also be mutual funds like the much-loved VTSAX. Mutual funds are traded privately and less transparent than ETFs or stocks on the public markets. Brokerage accounts might have higher fees to trade mutual funds. Mutual funds are traded daily (rather than real time with ETFs) and settle on a single price that everyone pays that day at close.
Mutual funds can also be more tax-efficient than ETFs. You can learn a lot more about Vanguard’s incredibly popular US market index funds in another post: VTSAX vs VTI.
Stock picking vs index funds
Not all investors feel that risk reduction through index fund diversification is worth reducing their upside investment potential. It is true that higher risk yields higher returns, on average, over time. This is a key point people talk about when discussing stock-picking vs index funds.
It’s one of the reasons that stocks tend to beat bonds in the longterm. It’s why lots of traders chase high beta (stocks with big swings up or down), as they think they can capitalize on the fast-moving changes better than others.
Jenni and I have been participating in the personal finance, FIRE, and investing Twitter-sphere since launching TicTocLife. Or at least, we’ve been trying to get the hang of it.
One of the threads I was following asked:
To my #dividend people: do you prefer dividend paying ETFs or picking individual stocks? Why?@MindingMy30s
Lots of the Twitterverse jumped on the individual stock bandwagon. While this is a question around dividends, the sentiment still applies to the general idea of handpicked individual stocks vs index funds.
Here’s a selection of comments:
- “For those just starting, a broad market index fund is often a good idea considering most investors can’t beat the S&P500. Then once you have that base, you can start picking individual stocks as they generally offer more upside + higher yields.”
- “Indiviudals. More opportunity to gain advantages. You’ll pick some losers, but if you do it right, the winners will outshine the losers better than an ETF can track.”
- “Individual stocks. I can analyse balance sheets. I choose what I want. Not what someone else picks for me.”
- “Picking my own individual stocks. I like to make my own mistakes Especially when the economy is strong, I feel better taking on riskier stocks with higher dividends Also avoids management fees…”
- “World class, blue chip, perpetual dividend increasing individual stocks. I can target undervalued companies, I can strategically reallocate the dividends, I can shift strategy and optimize my portfolio in response to current world events.”
- “Stocks. I like to know what I’m holding and have control. I like to know at what sort of valuation I’m buying the stock and don’t feel like it warrants an annual fee.”
- “Leaning individual stocks for now because a lot of them are still on a nice discount and have great growth upside.”
- “Individual stocks due to the tracking error some etfs have as well as the stable growth potential of one really solid company.”
Do you see a common theme here?
People want to have control.
People think they’re better than average at picking stocks.
Even as the first comment I highlighted mentioned that most investors can’t beat the S&P500 by picking individual stocks, they proceed to recommend them.
Passive vs. active investing
The common wisdom is that most people can’t beat the S&P500. I wanted to understand just how uncommon it was.
There’s a primary source many financial outlets cite to suggest that most investors can’t beat the market. It is an analysis performed by none other than the company behind the DOW itself: S&P Global. They publish a scorecard multiple times per year for different regions and industries around the world pitting active investors against passive indexes.
Per their 2019 year-end analysis, 70% of domestic equity funds lagged the S&P 1500 composite they track for the year. A similar result occurs internationally.
That means that the professionals, most of the time, can’t beat the market. These are the companies dedicated to financial analysis with all the research and tools available to beat individual investors into oblivion.
What chance do we amateur investor gals and guys have?
Some amateurs and some professional money managers will beat the market, but it’s luck and by extension—a very rare skill.
I know what some of you are thinking: “but I am that skilled!”
I’m making the assertion that it’s more luck than skill, not only from the 70% figure already discussed but also because the chances of beating broad market index funds with individual stock picks gets worse over longer periods.
Risk-adjusted stock return
S&P Global releases a risk-adjusted scorecard, that among other things we’ll discuss, tracks the active versus passive investing approach over a longer timeframe. Once the comparison is held over 10 or 15 year periods, the odds of passive indexes beating their active counterparts reach upwards of 90% in many different sectors.
As time passes, the chance a stock picker will beat index funds, decreases. With time, more chance is removed from the equation.
The risk-adjusted scorecard also accounts for, well, risk—it’s a common thought that though passive indexes may beat active managers, they often won’t do so during downturns. The rationale is that active managers will move funds into safer assets during a downtown, protecting the principal. Passive index funds will continue to match their index along with underlying businesses, right into bankruptcy.
The scorecard develops a clear methodology for how they ascertain risk-adjustment, but ultimately the result is:
Actively managed domestic and international equity funds across almost all categories did not outperform the benchmarks on a risk-adjusted basisRisk-Adjusted SPIVA® Scorecard
It’s important to note that this is even when the scorecard works from a gross-of-fee basis. This means that even where the analysis ignores the fees active managers charge they still lose to passive index funds. This is even where the comparison is risk-adjusted which active managers are supposed to be better!
Individual stocks vs index funds summary
Let’s do a little review and summarize the benefits of investing in individual stocks vs index funds.
Pros of investing in individual stocks
You could beat the market. It might be statistically unlikely as we review, but it’s not impossible. If your investment goals require you to beat the market, you’ll need to be willing to take on the risk necessary to do so. Index funds that represent the average of the market, sector, style, or industry simply won’t beat their underlying index. They’re the average after all.
You’re in control. If your net worth jumps based upon your stock picking—you did it. You’re the one that made the decision. Similarly, if your investments crater, it was your decision to won the stocks you picked. For some people, having this sense of control over their destiny is important.
Leverage your knowledge. If you have inside knowledge within an industry or product, you might be able to leverage that to make keen investment observations. Perhaps you work in the forefront of new technology or innovative product development. Investing in index funds will only water down the value of your inside knowledge.
Pros of investing in index funds
Less mental weight. By investing in index funds, you’re relying on professionals to do the research for you and create a diversified group of investments within your chosen sector. You won’t feel the need to monitor the progress of an individual company’s product development or particular knew technology innovations. You’ll earn your slice of investment returns through the index fund. You can get on with what you’re good at and enjoy your life.
Diversification. Even small, industry-specific index funds offer a huge advantage over individual stocks: they let you diversify your investments. By owning only a handful of individual stocks, you concentrate your investment returns. Sure, individual stocks might let you beat the market—but you absorb the risk of bankruptcy and other unexpected negative events, too. Managing a diversified portfolio of individual stocks would mean doing due diligence on many dozens, if not hundreds of companies.
Cost. Unless you’re willing to take on serious risk, index funds offer an incredible value through their diversification. With exceedingly low fees since they’re not actively managed, index funds offer exposure to hundreds if not thousands of companies. For example, VTSAX’s expense ratio is 0.04%. That means you pay a whopping $4 on $10,000 invested. Quite the deal to own part of about 3,500 companies.
Index funds vs stocks FAQ
It’s fun to tell a story, but let’s clear up some frequently asked questions about index funds vs stocks and do a little review.
It’s incredibly unlikely, but if all companies represented in an index fund were to enter bankruptcy, it’s possible.
Vanguard popularized index funds in the 1970s as a low cost way to own tiny slices of lots of companies the index represents without involving active money managers with high fees. Yes, they’re still a good investment but require due diligence like any other investment.
Yes. Our index fund investments have appreciated hundreds of thousands of dollars on our path to financial independence and reaching $1.2M in 2018. In the decade between July 2010 and 2020, a $10,000 investment in VTSAX would have grown to about $37,000. That’s a 370% jump!
Index funds follow specific policies and strategies to match their underlying index. Even if it seems clear to the investing world that a company is cratering, an index fund may continue to have to hold it right up until they’re delisted from the index. This was a hot topic with GM during the 08-09 Great Recession as GM reached bankruptcy. Index mutual funds can’t be traded as quickly as stocks though index ETFs can.
Index funds aren’t a specific asset type you can purchase. They come in two flavors: a mutual fund and an exchange-traded fund (ETF) which trades like a stock. Either one can reflect an underlying index of companies.
Got a question about index funds vs stocks we didn’t answer? Post a comment at the end of the article!
My Most Expensive Mistake
I dumped hours into learning how to evaluate company balance sheets, researching different industries, understanding commodity trades, and so much more during 2007-2008. Hundreds of hours that could have gone to improve my career skills, or hell, just having fun in my twenties!
I could have been working to build the life I wanted after figuring out how much money is enough for me.
I sold stock into the bottom of one of the worst bear markets in the last century, taking a realized loss larger than my earnings for that year. The experience delayed my return to the market for over a year, causing me to lose out on much of the recovery. The opportunity cost mixed with the realized losses easily beats out my terrible experience with lifestyle creep.
Had I simply kept the money in the market in an index fund, I could have been in a stronger financial position today and avoided the time sunk learning detailed investment theory.
Early retirement and freedom could have come even sooner.
That’s one expensive lesson.
What do you think about investing in index funds vs stocks?
What about passive versus active funds?
What’ve you learned from my mistakes?
Let us know in the comments!