Why do some investors prefer to invest in individual stocks, while others prefer index funds? It comes down to the returns they're seeking, and the time and effort they're willing to. If you're happy with 7-10% average returns each year, then truth be told, there's no easier way than to invest in broad market index funds such as VTI, VT, SPY, or VOO. Alright, well it's settled then…
But maybe, just maybe, you want to achieve higher than average returns in order to meet your financial goals sooner. For you, the temptation to invest in individual stocks may be irresistible. Let’s break this down.
Active vs. Passive
Everyone has heard someone they know say it. "Most actively managed funds don't beat the S&P 500 over long periods of time". The statement of this fact is often followed by something like "so what's the point in trying?" This sort of dogma can be harmful. Not because it's necessarily incorrect, but because it discourages people from following their curiosity with investing.
Look, i'm not saying that VTI and chill is a bad strategy, historically it's returned just shy of 9% since VTI’s inception in 2001. I'm saying that you should consider all of your options and follow the strategy that will work best for you and your goals. I mean, aren't you at least a little bit curious?
When people quote the fact that active underperforms passive their underlying logic is usually something like this:
“Most active funds don't beat the market, so any strategy that's not 100% passive will not beat the market, so you're crazy for considering anything other than investing in index funds”.
The point they're trying to make is that you shouldn't invest in individual stocks, try to time the market, or do anything else that requires brainpower. In my view, it's a very limited way to view things, and it's an emotional reaction to their own fear of the ‘unknown’ of investing. The problem is, it's a logical fallacy (read on).
Buffet's bet
Often cited in this argument is the famous bet Warren Buffet made in 2008. He bet $1,000,000 that a passive S&P 500 index fund would outperform a hand-picked portfolio of hedge funds over the next 10 years. It turns out Buffet was right. A hand-selected basket of hedge funds underperformed the simplest investment strategy in the world.
Now, this seems like a bold call by Buffett, but Buffett knows a secret that made him pretty comfortable making this bet. Hedge funds aren't set up to beat the market over long periods. Whaaaat? Yep, that's right. Most hedge funds are not optimised to produce returns higher than the market, they're optimised to make sure that investors lose less when the market drops. They do this through a range of different strategies such as options and shorting which we won't get into, but it's safe to say they are VERY active.
So, if hedge funds are super active and underperform the market, and investing in an S&P 500 index fund is passive and matches the market, we should never invest in individual stocks right? Again, this is not the correct comparison to make. The active vs. passive argument is actually about the frequency of trades and complexity of the strategy. It is not the same as comparing index funds with individual stocks.
If you had boughtMicrosoft and Amazon in 1999 and never touched your account, would you have done pretty well? Yes. Was that a passive strategy? Sure thing. Just becasuse you’re investing in invididual companies doesn’t imply an ‘active’ strategy, so it is logically incorrect to say that you shouldn’t invest in individual stocks because active funds underperform the market.
Beating the market
Contrary to popular belief, some investors do beat the market over long periods. Look at mr. Buffet himself - he's achieved a compound annual growth rate of 20% over his career, far outperforming the S&P 500. Closer to us mortals are Brian Feroldi and Brian Stoffel. They haven't been in the game as long as Buffett, but over the past decade their returns are somewhere in the 20-30% range, compounded. They’ve acheied this by investing in high quality, high growth technology companies.
So the question isn't 'is it possible to beat the market?', the question is 'what returns am I satisfied with'. Take fitness as an example. Want to be fit? It's pretty simple - just go to the gym a couple times a week and don't over-eat. Want to win an olympic medal? Well, that's going to take something more.
Another thing to keep in mind here - this debate of index funds vs individual stocks is a bit of a false dichotomy. You can do both! Perhaps you put 60% of your portfolio in index funds, and invest the remaining 40% in individual companies you love? The important thing is to stick with a strategy that works for you so that you let your returns compound long term, uninterrupted.
How to decide the right strategy for you
This assessment that will give you an indication of whether you should invest in index funds, individual stocks, or a bit of both. Ask yourself these questions and observe your responses.
How curious or interested are you about investing?
Do you think about investing or business regularly? Are you curious about understanding business models? Are you fascinated by legendary investors such as Warren Buffett or Cathie Wood?
If you have a genuine interest in business, investing, or finance then you will enjoy the process of researching and analyzing companies. This means it will be easy for you to continue to 'do the work' required to find great opportunities. Investing in individual companies isn't a one-time event, it's a journey, and it will help if you enjoy the journey.
If you really don't care about business or investing, and you're just investing because you know you 'should', that's totally okay! You're on the right track, and you can still do great. If this is you, the key will be to find a set and forget approach that doesn't require any brainpower or stress.
How much time are you willing to spend on your investments per year?
This ties with #1 quite closely. If you are interested in investing and enjoy research, you will likely make time for it. However this is still a worthwhile question to ask because it makes you consider how much time you actually want to spend doing this.
People want Warren Buffet sized returns, but don't actually want to be Warren Buffett. When faced with the reality of spending 10-20hrs per week reading annual reports and monitoring portfolio companies, those returns may not seem so desirable.
Do you have an edge in a specific industry?
Do you work at a software company? Does your partner or spouse run a business? Are your friends excited about a new product or service they're all using?
Do you have a unique perspective or knowledge in a specific industry that allows you to understand that business better than other people?
For example, let's say your partner runs an e-commerce business. She uses Shopify to host her store, and is constantly raving about the product and customer service. This sparks your interest, and you begin researching the company. After researching, you learn that Shopify is a high-quality business. It has great leadership, is growing like a weed, and their financials are rock-solid. You are confident that the company is going to do great things and you decide to invest. Your investment increases 10x since you invested.
Seeing your partner's love for the product and satisfaction with the value delivered was a unique edge that helped you to develop conviction in the business and ultimately invest. Are there areas of your life that give you a unique perspective or knowledge about a given business or industry? This could help you find truly wonderful investment opportunities.
Conclusion
So what did we learn?
Passive vs active and index fund vs individual stock are not the same debate although they are often treated as such.
Your personal investing strategy is just that - personal. Doing what works best for you, consistently, for a long time will yield results.
What sort of investor do you think you are? If you realized that you despise investing and you want to spend as little time as possible on it, then it's probably going to be better to do pure ETF strategy because it takes less work.
If you aren't an expert but you are excited about investing and you know a thing or two about your industry and can pick a few great companies you'd want to own, then maybe you take a hybrid approach.
If you are determined to compound your money at high rates (>10% a year) and you live and breathe this stuff, then investing in individual stocks may be the way to go.