Individual Stocks vs Index Funds

There has never been a better time to start investing than today. Gone are the days of relying on outdated technology and websites.
Today you can easily get started investing right from the palm of your hand. But with that ease of entry, can also come unrealistic expectations.
If you are looking for quick profits, investing is not for you. That is merely gambling. Those who do begin investing with the mindset of making quick profits, will overwhelmingly find themselves losing it all soon after.
There are no guarantees with investing. Unlike saving, investing in anything involves risk.
There are steps you can take to help mitigate the risk of your invested money, but it’s important to keep in mind that risk will always remain.
This is why investing is a marathon, not a race. We’ll talk more about risk tolerance and risk management a bit later in this module.

Getting Started

When you’re just starting, it may seem tempting to invest in the latest “hot” stock to make a quick return.
Day trading is often advertised as an easy way to double or triple your money overnight. It is the act of buying and selling stocks on the same day, multiple times a day, until you walk away with profit.
You may be tempted to day trade your way to wealth after hearing promises of high returns by “stock trading gurus.” But the desire for quick profits often leaves inexperienced traders with nothing more than stress and depleted bank accounts.
Many day traders can spend hours and days studying charts and data. But not even the experts ever truly know how stocks are going to perform over a given period of time.
And even if they do show you proof of big day trading profits, anyone can look like a genius in a bull market.
Remember how we discussed investing is best for the long term? While it doesn’t sound as flashy as day trading, I can tell you that exponentially more millionaires have been made by simply investing consistently and staying the course, than those who have attempted to day trade their way to there.
Anything that can make money fast can also lose it just as fast, if not faster.

Penny Stocks

One strategy day traders will try to sell you on is to trade penny stocks. According to the Securities and Exchange Commission (SEC), penny stocks are stocks that generally trade at less than $5 per share.
Penny stocks may also trade less frequently, meaning it may be difficult to sell your penny stocks once you own them. For this, and other reasons, penny stocks are generally considered speculative investments. In fact, the SEC warns of the pitfalls of penny stocks:
"Investors in penny stocks should be prepared for the possibility that they may lose their whole investment." - SEC.
Unfortunately, many new investors confuse penny stocks with stocks that are cheap, on sale, or simply just affordable. This couldn't be further from the truth.
If you're looking to invest in individual stocks that are affordable, you don't want to invest in penny stocks. Instead, you want to invest in fractional shares of quality stocks.  We'll discuss the advantages of fractional shares in our later module on the 7 investing automation strategies.
Jim Cramer, the host of CNBC's Mad Money, warns young investors that day trading speculative stocks is not investing. He reminds us, "they are penny stocks for a reason."
The truth is, 90% of day traders lose money. Some traders may outperform the overall stock market over a one, two, or even three year period. But over a 10+ year investing timeline, you will be hard pressed to find many who outperformed an investment in a simple S&P 500 index fund.
Because the odds are truly stacked against day trading, it’s not a recommended strategy for beginners. However, if you are interested in trading stocks, you may want to consider swing trading as an alternative.
Swing trading can provide many of the advantages of day trading, with much less volatility and potential risk.
We’ll go more in depth on the differences between day trading and swing trading in our later module on the 4 core investing strategies.
But first, let’s explore the better alternative to penny stocks for beginners. If penny stocks are the riskiest and most speculative investments, then what would be the least risky and safest investments?
You my friend, would be interested in index funds.

What are Index Funds?

When you are investing in individual stocks you are betting on the success and performance of a single company. And while you can “get it right,” and pick a winner, more often than not, you will have been better off simply investing in index funds.
An index fund is a selection of stocks grouped together designed to follow the performance of the underlying investments. Index funds track and replicate the performance of different areas of the stock market (i.e., the US stock market, large blue chip companies, small up and coming companies, etc.).
Perhaps you’ve heard of the age-old expression, “never put all your eggs in one basket.”
Why invest all your money on the performance of one company, when you can invest on the performance of the entire stock market? As cliche as that may sound, there is a lot of truth to it.
Because index funds are often composed of hundreds of stocks, they provide instant diversification. And because you are not dependent on the performance of a single company, investing in index funds can be a great way to help reduce risk in your investments.

World’s Greatest Investor Recommends Index Funds

One of the most widely tracked indexes is the S&P 500 index. As a representation of the performance of 500 of the largest US companies, it is often seen as an indicator of the overall performance of the US stock market.
Berkshire Hathaway CEO, Warren Buffet, is often regarded as the world’s greatest investor. Buffet recommends that most Americans simply invest in a low fee S&P 500 index fund.
In 2007, Buffet made a $1 million bet against the nation’s top hedge funds. He bet that none of the top hedge funds (managed by the top US fund managers) could outperform the S&P 500 index fund over a decade.
Ten years later, he was right. Over that ten year period, Buffet’s choice fund, the Vanguard S&P 500 Index Fund (VOO) returned 7.1 percent compounded annually, while the basket of hedge funds his competitor chose returned an average of only 2.2 percent annually.
  • Index funds can be a great form of passive investing. They hold every stock in an index such as the S&P 500, including big-name companies such as Amazon, Apple, Microsoft, and Google.
And because there is less buying and selling of stocks in index funds (as opposed actively managed mutual funds), fees and taxes tend to be low as well. Not only are index funds inexpensive, but they help manage risk in your investment portfolio as they aren’t dependent on the success of one single company.
The trick is not to pick the right company,” Buffett said. “The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently.”

How to Invest in Index Funds

As you can see, investing in index funds is a recommended starting point for most new investors. You get exposure to investing in hundreds of major companies, you don’t have to stress about picking individual stocks, and it can help manage your overall investment risk.
Quite simply, most new investors should start by investing in index funds. Now, is this to say that you should never invest in individual stocks? No, I am not saying that at all.
While nearly impossible to outperform the overall market through day trading, it is possible to outperform the market by investing in individual stocks. We’ll talk more about how to invest in individual stocks in just a bit.
With that being said, if you are just getting started with investing in the stock market, it is highly recommended to consider investing in an index fund first.
While you invest in an index fund you can begin to learn about the stock market and build your risk tolerance before investing in individual stocks.
When you’re ready to invest in index funds, there are two names you will often hear:
  • Mutual funds
  • Exchange Traded Funds (ETF)
Mutual funds are similar to index funds, but there are distinct differences you need to know about. And in the next video, we’ll be exploring their key differences and the reason I would recommend investing in ETFs instead.