A Constantly Recurring Question
Should an investor ever buy individual stocks or is it better to stick with a mutual fund of one sort or another? This question is the subject of a recurring debate among financial professionals, with some absolutely committed to a mutual fund only approach and others just as devoted to buying individual stocks.
The right choice for you depends on a variety of factors, most of which revolve around the amount of risk you’re willing to take and how much time you can devote to studying the market. You’ll understand these factors better with a little basic knowledge, so let’s have a quick look at the difference between investing in mutual funds and purchasing individual stocks.
Mutual Funds vs. Individual Stocks
- Mutual Funds
Essentially, a mutual fund is a way of investing that’s comprised of a pool of money collected from many different investors in order to buy securities like stocks, bonds, and other types of assets. Mutual funds are managed by a financial professional whose function is to invest the fund in a variety of assets and generate income for the individual participants.
There are many complexities involved in mutual funds, but their essential features can be summed up as follows for our purposes:
- They’re marked by high levels of diversification.
- Relative to buying individual stocks, they’re lower-risk.
- They require less time, knowledge, or effort on the part of the individual investor.
- Individual Stocks
Put simply, individual stocks are shares of a specific company. When investors purchase individual stocks, they’re essentially betting on a single company to succeed and generate a profit for them. There are many different pros and cons involved with buying individual stocks, but the short version is that some people succeed brilliantly with individual stocks, while others lose significantly. Here are some of the most important features of individual stocks:
- Unless you purchase individual stocks from companies that represent a couple dozen or so industries, your portfolio will not be diversified.
- Relative to mutual funds, they’re higher-risk.
- Success with individual stocks requires constant attention and a bit of luck.
Should You Ever Buy Individual Stocks?
The idea of making a huge stock market splash and getting rich quickly is a tempting one. That’s why so many people are looking to get in on the ground floor of the next Google or Microsoft. Unfortunately, there are at least as many colossal disasters (think Enron) as there are great success stories. Opinions differ on whether or not you should buy individual stocks, but the majority of experienced financial professionals counsel against it. The reasons? Because individual stocks can be difficult to manage for the average investor and riskier than most people have an appetite for. That being said, adding a few individual stock holdings if you already have a well-diversified retirement portfolio established may make sense.
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Here’s a quick way to decide for yourself. If you can give a definitive yes to all of the following questions, then individual stocks just might be a reasonable investment vehicle for you. Here’s what you need to ask yourself:
- Are you able to expose yourself to a certain level of risk without compromising other financial goals?
- Are you willing to spend several hours a day researching companies and learning about the market, or hiring someone else to manage your stock holdings for you?
- Do you have enough extra capital to purchase individual stocks? (above and beyond what is already allocated to your other spending, saving, and giving categories)
- Do you think you want to assume the additional stress that comes with the inevitable highs and lows of investing in individual stocks?
- Can you lose 100% of what you invest in individual stocks without suffering a major financial setback?
A Compromise: Index Funds
Of course, there’s much more involved in individual stocks than the previous five questions. Though, in almost every case, investing in individual stocks as a wealth-building strategy is not something we recommend for our long-term, goal-minded investors. The inherent risk tends to outweigh the potential rewards and simply aren’t necessary to reach financial independence.
That being said, there is a compromise between buying individual stocks and investing in mutual funds, and they are index funds. An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500).
We like index funds, because they can offer broader market exposure, which makes them less risky than individual stocks. They also typically feature fairly low operating expenses; in fact, they are downright cheap relative to other actively managed investment vehicles.
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Your investment strategy should be just that: a strategy. Therefore, before making any decisions about which investments you use to help you reach financial independence, attain your financial goals, and retire with enough money one day, have a plan based on your needs and goals. The right investment choices for you will largely depend on what you want to accomplish and when, but chances are individual stocks may complement an existing investment strategy at most.