Index Funds vs Individual Stocks: Which Is Better?

Any time you invest your money, you face an important question:

“What should I invest in?”

There’s a whole universe of stocks out there, and not all of them are good. In the future, some will go up and others will go down. There are thousands of stocks to choose from, and if you’re not careful, you could pick a loser. Faced with such a universe of choices, you have two options:

1. Buy a market portfolio (e.g., the collection of all stocks) through an index fund
2. Do extraordinary amounts of research to identify individual stocks that you think will deliver superior performance

The former option is certainly the easier one. But is it necessarily the better one? In this article, I’ll attempt to answer that question.

The case for index funds

The case for investing in index funds rests on one key point:

Risk.

Every asset is subject to two types of risk:

1. Specific risk
2. Market risk

Specific risk is the risk in any one company (e.g., the risk a pharma company’s drug won’t get approved), market risk is the risk facing all stocks. With individual stocks, you face both kinds of risk. With index funds that are sufficiently diversified, you only face market risk. The more stocks you own, the smaller your specific risk becomes. In a portfolio of thousands of stocks, specific risk is practically zero.

Consider the iShares S&P/TSX 60 Index Fund (TSX:XIU). It’s an index fund that holds a diversified portfolio of the top 60 Canadian stocks. If anything bad happens to any one stock in XIU’s portfolio, gains in other parts of the portfolio can make up for it. Let’s say that Enbridge (TSX:ENB)(NYSE:ENB) had its Line 5 pipeline shut down for some reason. That would likely cause ENB stock to plummet. XIU holds a bit of ENB, but the same news that would crush ENB wouldn’t necessarily destroy XIU. If other stocks in the portfolio went up enough to offset ENB’s loss, then XIU would not decline in price. So, XIU is less risky than holding an individual stock like ENB.

The case for individual stocks

The case for investing in individual stocks over index funds rests on higher potential returns. Note the key word “potential.” The “expected” return of an individual stock is not higher than that of an index fund, but the return in a best case scenario can be. If you’ve ever picked up a financial newspaper and read a story about a stock going up 1,000% in a few years, you might be amazed. But with individual stocks, such returns are not all that uncommon. They’re certainly not the norm, but they can happen. With indexes, such results don’t occur. The heavy diversification they have means that the “multi-baggers” in the portfolio are offset by many hundreds or thousands of other stocks that didn’t do so well. So, the “best-case scenario” with an individual stock beats that of an index fund.

There is also a case to be made for investing in individual stocks for specific desired characteristics. If you want an extremely high dividend yield, then you can go out and lock in 6.5% by buying ENB today. You won’t get such a yield by buying XIU or any other North American index fund. If there are specific characteristics you want disproportionately in a portfolio, you need individual equities to get them. Index funds, by definition, have a bit of everything.

The post Index Funds vs Individual Stocks: Which Is Better? appeared first on The Motley Fool Canada.

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Fool contributor Andrew Button owns iSHARES SP TSX 60 INDEX FUND. The Motley Fool recommends Enbridge.