Index fund investing is incredibly popular as the most passive way to invest in the stock market -- but if you lean too heavily on this strategy, you might just be selling yourself short. Individual stock investing puts you directly in control of your money. Keep reading to see why you may be leaving money on the table with index investing.
Instant diversification -- just add cash
When an investor buys an index fund, they buy into a basket of stocks that tracks a given index. This immediately creates a portfolio of companies that the investor now holds. If you bought shares of an index fund that tracked the S&P 500, your holding would mimic the changes of that index, both in terms of returns and allocation.
Index funds are often referred to as one of the most passive ways to invest because the team behind them doesn't need to individually choose components -- they simply replicate an index. This why index funds tend to charge significantly lower fees than their actively managed counterparts. Actively managed funds select their components with the goal of outperforming the market, but the majority fall well short of this mark because of their excessive fees.
Index funds appeal to many investors because of their low fee structure, hands-off approach, and instant diversification. But while index funds may have their advantages over actively managed funds, they are designed to track the market, not outperform it. When you buy individual stocks, you create a third option: beating the market.
Manage your own fund with individual stocks
When you own an index fund, you own all of the companies in that fund. While the S&P 500 may include a whole lot of amazing companies, it also includes quite a few duds -- sorry, Xerox. Unfortunately for us investors, when we invest in an index fund, we are stuck with the allocation of the index.
Why own companies like Xerox, whose best days are long behind them, when you can own a company that looks toward the future? Do you really think it will become increasingly important to have documents photocopied? Etsy is another component of the S&P 500, but that is where its similarities to Xerox end.
Etsy is a leading digital marketplace for artisans and consumers who want handmade crafts, and as a company, it is in a position to grow as e-commerce becomes more and more integral to our daily lives. Do you want to own the Xeroxes of the world? Would you rather own more of Etsy than the 0.05% of the S&P 500 that it composes? You can do this by investing directly in Etsy.
Nowadays, commission costs for trading stocks are virtually nonexistent, which means you can buy a variety of the companies you love without worrying about excessive fees. When you invest in individual companies, you give up the no-brainer, hands-off nature of index fund investing, but in return, you take charge of your portfolio.
Determine your holdings, and let them run
Market capitalization determines the allocation of a company within the S&P 500, with the largest companies carrying the most weight. This is a double-edged sword for investors: Larger companies are less likely to disappear, but smaller companies aren't really able to move the needle. For example, since Amazon (NASDAQ: AMZN) joined the S&P 500 in 2005, the index has returned a solid 273%. However, if you had just invested in Amazon that year, you'd be up an insane 65,000%. If you were a patient investor who bought Amazon directly, you'd be sitting pretty right now.
Unfortunately for index fund investors, as companies in a given index get too big, fund managers sell off their position to keep the allocation to a predetermined level. As the value of Amazon shares skyrocketed over the past 15 years, you'd have missed out as the people running the index fund sold off part of your shares in the company. Why not let your winners keep winning?
Beating the market is within your grasp!
Why settle for market-performing returns when you can invest your hard-earned capital into the companies that you want to own, and beat the market all the while? When you invest in individual companies, you put your trust (and money) in the companies that are up to your standards.
No, individual stock investing is not as hands-off as index investing, but it has a lot more potential for return. Investing in individual stocks can be intimidating for fresh-faced investors, but many great starter stocks share some common traits. With low barriers to entry in the investing world, now may be the best time yet to build a diverse portfolio of strong, individual companies.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Edward Ruger has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and recommends the following options: short January 2022 $1940 calls on Amazon and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.
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