Index Funds vs. Individual Stocks: What Finance Students Actually Say

An important distinction to make is what will happen when we invest into index funds vs. individual stocks.

It is fairly common today to think that the best way to make money in the market is by picking individual stocks. Friends, peers, teachers, and relatives may provide you with a stock tip from time to time, or try to clue you in on the next big company. 

The truth is, you don’t have to pick out the next Apple or Nvidia in order to succeed in the stock market. There are plenty of ways to generate consistent and respectable returns while managing risk.

The Case for Boring Investments

I know it may sound boring, but index funds are the powerhouse driving the growth of many portfolios. An index fund is a type of investment that seeks to track the returns of a market index (list of securities and/or stocks). The most common market index is the S&P 500, which seeks to follow the 500 largest companies in the United States.

Sure, it can be less exciting to invest in indexes because it doesn’t feel unique, or require any attention and individual research. 

But by instantly diversifying through an index you mitigate your financial risk while maximizing the potential for long term profits through compound interest. This is especially true for beginners. The best way to enter into an index fund is through an ETF. To learn more, check out my post: What is an ETF? A College Student’s Plain-English Guide.

Long story short, index funds have a lot going for them.

What the Data Says About Index Fund Returns

Index funds generate a surprisingly high rate of return for investors who are willing to stick it out for the long run.

Here are the average returns for a few of the most popular indexes over the last 20 years:

• S&P 500 – 11.5% annual returns
• NASDAQ 100 – 15.5% annual returns
• DJIA – 10.5% annual returns

Source: historical index data via Macrotrends

This is not to say that there will not be any variance. In times of financial crisis (like during 2008) these funds can lose 40% of their value or more in a single year. Scary. But the magic of index funds is in their consistent returns when looked at as a long term investment. 

Lastly, here is a stat to put this into perspective: 90% of professionals (large-cap fund managers) fail to beat the returns of the S&P 500. With all the advanced trading tools in the world and teams of analysts, even these fund managers struggle to outperform indexes. This stat is not meant to discourage you, but it does highlight the fact that these boring investments don’t mean bad investments.

The Appeal of Picking Your Own Stocks

On the other hand, choosing your own stocks has the potential to be a fun and rewarding way of investing. Compared to index funds, it is much more exciting to research a company and develop “the story” around why its stock will go up. 

There are two main ways of approaching stock research: fundamental and technical analysis.

Fundamental stock analysis consists of checking up on the prosperity of the company, either by looking at the profits, debts, and what the company actually owns. These values are usually found by looking at the financial statements of a company. Fundamental analysis seeks to help someone properly conceptualize the real value of a stock. 

Technical stock analysis is different, and seeks to understand where a stock is at based on previous price movements. Technical analysis doesn’t take into consideration how well a company is doing, but rather only focuses on where its market price is going. By looking at price charts and indicators, technical analysis uses patterns to value a company.

As you read more of my posts, you will find out why I believe fundamental analysis to be the better option for almost every investor.

The Risk Nobody Talks About

Peter Lynch, one of the greatest investors and stock pickers ever, was under the impression that most amateur investors don’t actually invest, but rather are gambling with their money. This boils down to the fact that many people don’t actually understand the companies whose stock they buy. Lynch believes this is the number one reason most investors fail when picking stocks.

While ignorance of fundamental analysis is very common, there is more risk when buying individual stocks because of the lack of diversification. Companies can go south very quickly, and it is good to remember that there are no safe stocks. Even the best stocks in the most defensive sectors can struggle every now and then.

Picking stocks seems like a high-risk-high-reward game, where the luckiest investors end up on top, but this doesn’t actually have to be the case. “Value investing” is a term used to describe how fundamental analysis provides an investor with the proper valuations to understand when a stock is undervalued at market and price.

What a Finance Major Actually Recommends

My recommendation would be to stick to index funds if you are an absolute beginner to investing. If you are brand new to investing, check out my post: How I Would Invest $500 Starting from Zero. Index funds are the best way for someone who doesn’t know the ins and outs of fundamental analysis to take advantage of all the growth in the stock market. 

It takes time to learn how to pour over different numbers on the balance sheet and calculate certain ratios that aren’t always given. But, if you have a strong foundation in fundamental analysis and are able to value companies properly with respect to the rest of the market, then go ahead and explore individual stock picking.

It depends on your experience level and the time you are willing to commit to your own stock research.

If you enjoyed this post, feel free to join our newsletter to stay updated with any future content we release.