One of the biggest questions investors face is whether to invest in individual stocks or index funds. Some investors don’t have much of a choice. Company 401(k) plans limit your options to index or mutual funds. For those that do have a choice, it makes sense to see what is right for you. Get rid of your pre-conceived notions and research what actually makes more sense for you. I’ve invested in both stocks and index funds over the last 15 years. One isn’t necessarily better than the other. They both have pros and cons.
Pros of Individual Stocks
1.) You control what you want to buy. You can pick the stocks with brands that you use/like. This is one of Peter Lynch’s big ideas for investors, buying what you know gives you an advantage over Wall Street. You can check out notes to Peter Lynch’s One Up on Wall Street here. I read this book years ago. The one thing I took from it is that 10-baggers are possible and you may be able to identify these companies before the Wall Street pros. Lynch uses the example of Leggs, the brand of panty hose that his wife kept buying every few weeks. He thought it was a great business model so invested and this yielded great results. Some things to remember though are that for every Leggs, there are multiple failures where you will lose money.
2.) You can sell your losers for tax advantages. It’s December 31st and you’re looking for stocks to sell from your portfolio. Why? Because you have an extremely competent CPA who advises you to sell your losers with the option to buy them back 30-days later. I have more on tax-loss harvesting in this article about beating the tax man like a red-headed stepchild. There are ways to lower your taxable income and you should know them.
3.) Ongoing costs are extremely low. Like zero. After pay a small commission or possibly no commission, your ownership costs are nil. There are no ongoing management fees. You can easily see your costs with individual stocks. You pay $5 to buy 1,000 shares of XYZ stock and that’s it! I do recommend only paying commissions that are less than 0.2% of the total purchase price. That’s $2 for every $1,000 of stock purchased. And if you can get away with lower costs you should do that too.
4.) You can set up your portfolio to pay you income on your terms. The great thing about individual stocks is the FREEDOM to choose your income. It can become very powerful to set up a dividend income portfolio that generates a certain amount every month. For example, you could have a 20-stock portfolio totaling $1,000,000 that pays you $4,000 in tax-advantaged monthly income. It’s like having an ever-increasing annuity that gives you almost guaranteed money. Companies don’t take dividends lightly. Once they start paying them, they continue to pay them and increase through time.
Cons of Individual Stocks
1.) It’s hard to diversify and structure your portfolio. It’s harder to figure out if you’re properly diversified. It’s not a huge deal but you have to be educated on sectors and correlations. If you own 10 stocks and 9 of them are in financials, you’re not diversified. Having a bunch of companies in the same sector is risky.
2.) It takes time to look into each stock. The finance bug bit me early in life. I would research stocks for fun and literally could recall tickers on 80% of the S&P. Maybe that was excessive but when you’re interested in something it’s pretty easy to wrap hours into it without realizing. I would even read those massive Value Line reports that showed the companies earnings history, prospects, competition, etc. I know most people don’t have time for this. I get it. I actually am more like that now too. I’m trying to simplify everything.
3.) You can be hit by company specific issues like accounting scandals. That’s the biggest thing I’m scared of when investing. Accounting scandals are like nuclear disasters to your portfolio. You can’t see them coming but when they hit, it’s too late. You’re dead. So it’s always good to keep at least 12 stocks in your portfolio and I would argue that 20 stocks is probably ideal for most individual stock pickers.
Pros of Index Funds
1.) It’s easier to diversify your portfolio. You can literally buy one fund and be completely diversified. Warren Buffett argues that most people should simply buy an index fund in the S&P 500 and forget about everything else. For some people this makes sense. It takes zero time and thought but there is a cost that you’ll see below.
2.) It’s hands off and gives you peace of mind. You don’t want to research stocks all the time. Investing passively is easy and you don’t have to worry about individual stocks blowing up. You’ll be able to enjoy vacations more, not worrying about losing thousands a day on a swing trade that got squirrely on you.
Cons of Index Funds
1.) You could be overpaying because you’re not following the underlying stocks. You’re not checking the valuations of the underlying stocks before you make purchases in an index fund. I don’t. And if I don’t, very few people do. Let’s face it: it’s a waste of time anyway. You could instead make a commitment to only purchase shares in an index fund if the index itself goes below a certain valuation. For example, you could only invest in the S&P 500 index if the P/E ratio of all the stocks combined trades at less than 20. You could also put a different ratio in place of the P/E like the CAPE, which accounts for the last 10 years’ earnings. That would probably be the best way to do it if you want to change your allocations based on valuations.
2.) You invest in the best and the worst stocks of the index. Index funds let you buy the BEST and WORST companies. If you own a S&P 500 index fund, you invest in the top performing companies (e.g. Nvidia, Facebook, Google, Amazon, Netflix, Activision Blizzard, etc.). The problem is you’re also investing in the worst performing companies in the S&P 500 (e.g. Macy’s, Range Resources Corp). Some companies are just not good investments. They’re in sectors that are in a secular decline. Take coal for instance. Companies in the coal sector have underperformed for a decade. Many have gone bankrupt. When you invest in index funds, you’re bound to get some secular declining laggards that would be better off just filing for bankruptcy and exiting public markets. Not all companies make more than their cost of capital. When this starts happening, the company is doomed. Enter the Under Taker.
3.) Fees are lower than actively managed mutual funds but there are ongoing cost.
Investing in index funds makes zero sense if you’re a value investor. There is the issue of forced buying when it comes index funds. More people making more contributions to funds forces the fund managers to buy more stocks. If I’m a fund manager and people are sending me money, I have to invest it if I’m an index fund. I don’t care about prices at this point; just trying to represent the index. You can see how things can get out of whack here. What if everyone sells out of their 401(k) accounts en masse? Forced selling and a steep drop in asset prices would result. The next great market disaster could be flamed by so many people buying into index funds in recent years.
What About Allocation?
Whether you invest in individual stocks or index funds is not as important as the allocation you choose. After all, stock index funds are simply made up of underlying stocks. We’ve gone over the pros and cons of each. But none of that matters if your allocation is out of whack.
Allocation should be based on price (or valuation / how expensive the market or stock is). Chapter 8 of The Intelligent Investor lays out some key indicators of a bull market:
1) Historically high price level (overall valuations)
2) High p/e ratios (also look at the CAPE for cyclically adjusted earnings)
3) Low dividend yields against bond yields
4) High margin debt (speculation)
5) Many new IPOs of poor quality (I would add here over-hyped rip-off IPOs as well.)
Graham says that while market timing isn’t the best, he does believe that changing your allocation when you’re deep into a bull market makes sense (tactical asset allocation). For instance, in a stock bull market, Graham says shift some of your money into bonds.
“Our recommended policy has, however, made provisions for changes in the proportion of common stocks to bonds in the portfolio, if the investor chooses to do so, according as the level of stock appears less or more attractive by value standards.” ~Chapter 8 The Intelligent Investor
So what does “changes in the proportion of common stocks to bonds” mean to Graham? He believes that your allocation should range between 25% and 75% stocks, with the inverse of that invested in bonds. That percentage is very wide for a reason. If stocks are way overvalued based on the 5 points at the beginning of this section, Graham thinks you should only have 25% allocated to stocks.
At this point it may be hard to determine the percentage of stocks to bonds that you need in your portfolio. Some of the warning signs of an aged bulled market are subjective. For instance, how many new crap IPOs constitute enough to be alarming? I’m not sure.
I’m a defensive investor and so the objective of my portfolio is to minimize risk while still achieving a decent return. Notice I didn’t say maximize my return. I could probably get more return on my portfolio but this wouldn’t fit with my risk strategy. I’ve designed the Triad Portfolio to help guide my investing process, with allocations to risk-free, core, and alternative investments. I recommend everyone make sure they’re properly diversified across asset categories (stocks, real estate, cash).
Are We All Suckers?
This leads me to wonder why so many investors think you should simply buy stocks without regard to price and never adjust your allocation. Are we all suckers? It’s very simplistic to say just buy stocks and don’t try to time the market. But the issue is you shouldn’t buy investments that are overvalued. You also shouldn’t just blindly follow some platitude.
People who say to just dollar-cost average and invest without regard to price are leading the sheep to slaughter. Let’s say you invest bi-weekly through your 401(k). Let’s also say you’ve picked an index fund and allocate $500 from your bi-weekly paycheck to this fund. You, the investor, are buying shares in the index fund without actually determining the share price represents a good value.
You could be investing through an index fund in a way you’d never invest through individual stocks. Let’s say you’re investing in a S&P 500 index fund bi-weekly through your 401(k). You don’t care what price you’re buying into the fund. On the other hand you also invest in individual stocks. You see that Apple, Amazon, and Facebook are all trading at valuations that are too high for you to justify. But wait, these are some of the largest companies in the S&P 500, which you don’t mind buying blindly.
I’m Selling Stocks
That’s right, I’m selling stocks. I’ve been 90% invested in stocks for years. Stocks have gone up and up and it’s been a good ride. Time for a change. I’m following Graham’s own advice and reducing my exposure to stocks for bonds and alternative assets.
I invest in individual stocks so reducing my exposure to them is interesting. I have to comb through my portfolio and figure out which stocks are overvalued or that I think won’t increase more than the overall market. I also look for crap stocks (I know I should be less technical) in my portfolio. Found one…Oneok (OKE) has been that for me. This thing has stunk to high heaven due to being tied to oil prices. Sold. I also sold all my REITs and Utilities last year and you can read about my reasoning here.
Now this doesn’t mean that I’m selling everything. No way. There are still some companies out there that represent a good value. And I’m ready to go back into stocks if we slide into a recession or see some type of big correction. The pendulum swings up and down. The market will move in both directions. Bull markets can stick around for a long time, leading people to believe that they’ll keep going up.
Should I Invest in Individual Stocks or Index Funds?
Most people think that only excessive risk-taking idiots invest in individual stocks. I think that people who simply invest in index funds, without regard to allocation, could be taking more risk than they think. There is no right or wrong answer. You have to consider your investment objective and the time you have available to invest. Some people want to be hands off. Others want to blaze their own path.
I invest in individual stocks for the most part (outside of my 401k) because I like the FREEDOM to choose my path. I’m also a finance nerd and actually enjoy researching companies. I don’t think I can “beat” the market or anything although I have for years. I like to set up my portfolio so that I get paid dividends and options premiums. I also seek value stocks that I think have a good margin of safety. Can’t do that with index funds.
What are your thoughts on investing in individual stocks versus index funds? Do you think we’re currently in a late-stage bull market according to Graham’s indicators? I’m reducing my exposure to stocks and I’d like to know what you’re doing.