Stocks vs Index Funds: Which is Right for You?

For new investors, which is better: buying individual common stocks or low-cost index funds? Financial planners feel passionately about both positions. Here are some of the pros and cons of each so you and your own advisors can decide for yourself.
For new investors, which is better: buying individual common stocks or low-cost index funds? Financial planners feel passionately about both positions. Here are some of the pros and cons of each so you and your own advisors can decide for yourself. Tempura/Getty Images

Stocks vs. Index Funds.  Which one makes more sense in your investment portfolio?  It's a common question so many investors have asked when starting their investment journey.  If you have ever picked up a financial magazine or spoken to a handful of financial advisers, you know there are some pretty strong opinions about whether investors should buy individual stocks for their portfolios or choose a collection of low-cost index funds.

 For some investors, their belief in index fund investing runs so deep, it's almost like a religion to them, telling anyone willing to listen to buy index funds until the cows come home.  For others, they sleep better at night knowing their portfolio consists of individual companies they researched in-depth and hand selected.  There is a lot of noise out there, and to help you decipher all the different messages you've read, I thought I'd provide you with a brief overview of some of the benefits and drawbacks of each school of thought.

Investing in Stocks

When you buy shares of stock in individual businesses, you become a part owner of the company.  That means you should get a proportional share of the profits or losses depending upon the success the business experiences.  For example, let's say the McDonald's Corporation earned $4,551,000,000 after taxes in profit, and the company's Board of Directors decides to mail $2,465,300,000 of this back to the company's stockholders in the form of a cash dividend.

 Because there are 1,010,368,852 shares outstanding, this works out to $2.44 per share.  If you owned 1,000 shares, you received $2,440 in cash.  If you owned 1,000,000 shares, you received $2,440,000 in cash.

Investors who bought ownership in successful companies in the past have grown very rich.  Imagine if you became part owner of Microsoft, Google, Berkshire Hathaway, Coca-Cola, Nike, eBay, Target, Disney, or American Express when they were small.

 As their profits grew, you benefited based upon the total ownership you held.  In fact, a $10,000 investment in Wal-Mart when the company first issued stock to outside investors, has now grown to more than $10,000,000 with dividends reinvested!

On the other hand, companies fail.  Sometimes, they slowly atrophy like the American car manufacturers. Other times, they end in a spectacularly catastrophic meltdown, like Enron.  If you own stock in these companies, your shares might be worthless, just as if you owned a local bakery that had to shut its doors.

Investing in Index Funds

When you buy an index fund, you are really buying a basket of stocks designed to track a certain index, such as the Dow Jones Industrial Average or the S&P 500. In effect, investors who buy shares of an index fund own shares of stock in dozens, hundreds, or even thousands of different companies indirectly.

Someone who invests in an index is basically saying, "I know I'll miss the Wal-Mart's and McDonald's of the world, but I will also avoid the Enron's and Worldcom's of the world.  I just want to make money from corporate America by becoming part owner.  My only goal is to earn a decent rate of return on my money so it will grow over time.

 I don't want to have to read annual reports and 10Ks, and I certainly don't want to master advanced finance and accounting."

Statistically speaking, 50% of stocks must be below average and 50% of stocks must be above average.  This is why so many index fund investors are so passionate about passive index fund investing.  They don't have to spend more than a few hours each year looking over their portfolio.  Whereas a stock investor in individual companies needs to be familiar with a company's business, its income statement, balance sheet, financial ratios, strategy, management, and more.

Although only you and your qualified financial planner can decide which approach is best and most appropriate for your own situation, as a general rule, index fund investing is better than investing in individual stocks because it keeps costs low, removes the need to constantly study earnings reports from companies, and almost certainly results in being "average", which is far preferable to losing your hard earned money in a bad investment.