Individual Stocks vs. Index Funds

I’ve always been a fan of stock trading and have generally steered away from diversification.  That is, until recently.  Though not entirely by choice, I’ve come to realize that there are many gains to be had and risks to be avoided by choosing the overall market over individual stocks.

My transition away from stock trading started when I joined my law firm.  Ironically, I chose to be a lawyer so that I could make more money to buy more stocks.  Unfortunately, the firm has a strict insider trading policy that restricts us from trading in any company that the firm either represents or has material nonpublic info.  Even if I don’t have access to that info, I can’t trade if there’s a potential conflict of interest with the firm.* 

So as a result, I’ve sold off most of my stocks before starting work and now primarily invest in index funds (e.g., VTI, VFIAX or VYM).  What are the advantages of index funds?  Well for starters, these are the way to go when you’re a risk adverse investor.  That’s because index funds track either the overall market or some segment of the market.

Many of us have heard the saying that investing in stocks is the only way to beat inflation.  And fancy graphs of the rising S&P 500 or Dow Jones Industrial Average seem to prove that point.  So investing in the stock market is a good idea, but that doesn’t mean investing in individual stocks is always a good idea.  Take Lehman Brothers (LEH) for example.  This financial services firm went up in smoke in 2008 and you would’ve lost all of your money if you had invested it in LEH stock.

But what if LEH was part of the index fund that you invested in?  Wouldn’t its bankruptcy cause the value of the entire fund to drop?  Not necessarily.  Let’s look at the S&P 500 for instance.  That index is comprised of the 500 largest companies that are listed on the NYSE or Nasdaq.  If LEH was one of the top companies listed, it no longer would have been once it collapsed.  Another company would have quickly taken its place.  So if you invest in a fund like VFIAX which tracks the S&P 500, your money would always be safely invested in the current top 500 companies, not the ones that went bankrupt and got shuffled out.  This survivorship bias is why the S&P 500 has consistently risen over time.

So to sum it all up, if you want the security of investing in only the best companies, you’re better off investing in index funds.  If you’d rather divide your eggs into a few baskets, then stock trading would be a better choice.  In the end, if you choose companies with strong fundamentals and buy their stocks at the right times, the likelihood that you will encounter a bankruptcy is slim.  But that likelihood is even slimmer with index funds, and you’ll save yourself a lot of time from having to research your stock picks.**

*The worst case would be if a conflict of interest developed after I bought the stock.  Then I’m restricted from selling the stock until that conflict of interest has been resolved.

**Check out this article on Warren Buffet’s $1 million bet that a plain index fund will outperform high-fee hedge funds that actively trade in individual stocks. 

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