Many investors have found success in seeking out passive index funds with low expense ratios. These funds replicate the holdings of major stock indexes like the S&P 500, as well as more specific indexes that track certain industries. They offer benefits like widespread diversification and low turnover. When combined with disciplines like dollar-cost averaging and reinvesting dividends, index funds have helped even novice investors build wealth.
So why wouldn't someone invest through index funds, if it's such a great deal? While index funds have benefited many investors, sophisticated investors with deft analysis skills may find that they can replicate the success of index funds through alternate—and potentially more beneficial—methods.
Investors Found Success Before Index Funds
Index funds are a relatively new financial tool. The first index ETF, the S&P 500 ETF SPY, didn't make its debut until 1993. However, individuals have been building wealth with stocks well before the '90s.
Many successful investors throughout history have built wealth using the same underlying principles that Jack Bogle identified when he first created the index fund. However, there's one exception, they substituted valuation of individual securities with regular purchases, using skill sets in accounting to value stocks like they would with private businesses, real estate, or bonds.
These people were not all stock traders. They were not actively chasing hot shares on the rise, like a stereotype out of an '80s movie. They are people like Anne Scheiber, who left behind $22 million after a life of slow and steady investing, or the dairy farmers with eight-figure net worths who kept their wealth a secret from their children.
These are people who spent years putting together a portfolio of companies. The analysis tools available to them are available to you today. Some investors may prefer to follow in their path, rather than buying an index fund.
Tax Benefits to Individual Stock Picking
Imagine you wanted to mimic the S&P 500 or Dow Jones Industrial Averages. Instead of buying a mutual fund or index ETF, an investor with enough cash could just as easily build the index themselves by purchasing the underlying shares of stock that make up the index. Building the portfolio yourself, instead of buying into a ready-made index fund, will save you on the expense fees that fund managers charge. It could also allow you to take advantage of advanced tax harvesting techniques.
Index Funds Limit Investor Choice
Buying an index fund is, in a way, outsourcing your thinking to someone else. In the case of investing in an index fund that tracks the S&P 500, for example, the stocks in your portfolio depend on market capitalization, which is in turn decided by how much investors are willing to pay for stocks. There's human judgment involved, just not yours.
Furthermore, when an index is based on market capitalization, stocks are effectively bought as they become more expensive (and their market cap qualifies them to join the index) and sold when they become cheap (and they no longer qualify to remain in the index). This goes against the common phrase "buy low, sell high," but passive index investors are powerless to decide the stocks in their portfolio. By picking stocks directly, an investor chooses exactly when to enter and exit the position.
Investors that pick stocks can also choose to avoid any sectors that they feel uncomfortable adding to their portfolio. For example, a cyber attack in someone's history may have left them with insecurities about technology. That person, if they only invest in broad index funds, can't help but invest in the tech sector. However, by picking the stocks themself, that investor can avoid tech stocks and enjoy peace of mind.
Reasons to Use an Index Fund
While sophisticated investors certainly find situations in which it makes sense to avoid index funds, there are also plenty of investors who find that index funds best fit their goals.
The most common scenario that lends itself to index funds is when an investor lacks knowledge. For instance, a bank employee may be intimately familiar with the finance industry. This person feels confident picking bank stocks, but when it comes time to look at companies in other industries, they struggle to parse through the data. This person may choose to bolster their individual bank stock picks with index funds that track other industries, thereby giving themselves a well-rounded portfolio that represents the broader economy.
Beginning investors may struggle with understanding corporate data in general. This could be another scenario in which index funds best fit the investor's goals.
A sophisticated investor who finds success in individual stock picking might choose to shift their investments to index funds as they get older, so they don't have to worry about their family making investment decisions after they die. Warren Buffett built his fortune on his ability to pick stocks. But when he dies, he has said that his wife won't be left with a portfolio filled with individual stocks. Instead, the estate will put 90% of the funds in a low-cost S&P 500 index fund, and the other 10% will be put in short-term government bonds.
The Bottom Line
Index funds remain a compelling way for many people to take advantage of equity ownership, particularly if they aren't interested in evaluating individual businesses they might want to acquire (or lack the time and energy to do so).
When in doubt, there's no need to make a definite choice between the two investing strategies. Nothing's stopping you from indexing a large percentage of your assets, but keeping a bit on the side to experiment with researching and buying individual stocks.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.