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When it comes to stock market investing, there are a lot of options and different terms that get thrown around. If you’re just starting, it can be overwhelming at times.
But don’t worry, that’s why I’m here.
I’m going to break down the two most basic investment types: index funds and stocks. After reading this post, you’re going to learn which investment would better suit you and your goals.
What is a stock?
Let’s start with the basics. First off, what is a stock?
A stock is a share of ownership in a company. When you invest in a stock, you’re buying a piece of the business. You become a partial owner of the business. If the company does well and its shares increase in value, then so do the shares that you own.
You can continue to hold your shares as it increases in value or chose to sell them at a higher price.
There are two types of companies: private companies and publicly-traded companies.
Private companies are companies that do not offer stock to the public nor consult the public regarding business decisions. These are the companies you cannot buy stock in.
On the other hand, public companies are the ones that offer stock to the public. Being a publicly-traded stock means anyone can buy shares and become a partial owner of the business. Shareowners of the company will have voting rights in decisions regarding the business.
What is an index fund?
While a stock represents a single business, an index fund carries multiple different stocks.
Think of an index fund as a basket full of different stocks from different sectors. By investing in an index fund, you’re investing in all the stocks that the index fund carries.
Let’s say, for example, you wanted to buy the top 500 companies in the United States. Instead of wasting time trying to buy 500 stocks, all you would have to do is invest in an S&P 500 index fund. You can invest in index funds with as little as $1, as many brokerages these days offer fractional share trading.
How much does it cost to invest in an index fund?
Index funds are one of the cheapest investments you can have. Because they’re passively managed to simply track an index, index fund managers charge a negligible fee every year.
This “fee” is called an expense ratio. The average expense ratio of index funds ranges anywhere from 0.015% up to 0.04%.
In other words, you’re only being charged 0.015% – 0.04% of your portfolio per year. If you have $10,000 invested in an index fund, you would only be charged $1.50 – $4.00!
Active vs. Passive
Let’s get into the details of whether stocks or index funds make a better investment.
Investing in individual stocks requires you to be an active investor. You need to actively keep up with the financial markets while making sure your fundamental analysis is on point.
Businesses are like breathing, living beings. They constantly change internally and may also change due to external factors such as the economy or trend changes. Therefore, for stock investors, it’s always important to make sure you’re on top of your research.
On the other hand, index funds are much more passive. The fund managers take care of all the hard work. Once you choose an index fund you want to invest in, all you have to do is sit back, relax, and watch your money grow.
If you want to be an active investor with more hands-on time, I recommend investing in stocks. If you want to be a “set and forget” type of investor, index funds are the way to go.
Reward Potential
Now let’s talk about the reward potential for stocks vs. index funds, the part that everyone wants to know about.
Stocks have a higher potential for reward, while index funds are less volatile and safer.
The reason why stocks have a higher potential for returns is that they’re riskier. It all comes down to risk vs. reward. If an investment is riskier, there will be a higher potential for returns.
Stocks carry more risk because they’re a stand-alone investment. If you’ve invested into a single business and that business goes bankrupt, you will lose all of the money you’ve invested.
A single stock also has the potential to jump up 500% within a single month. Those are some outstanding returns, but remember that the stock market is not a lottery machine. Make sure you’re doing your research because speculation is risky.
Index funds have a lower potential for return, but they’re a safer investment. Returns are slow but steady, generally yielding around 9% per year.
The reason why index funds are safer is that your money is spread out among many different stocks. Investing in an S&P 500 index fund would mean your money is spread across 500 different stocks.
Although one business may go bankrupt, you still have the 499 stocks that’ll keep your investment afloat.
It’s important to note that the market goes through downturns and your portfolio of index funds will experience some volatility. However, historically, the market as a whole has always rebounded, 100% of the time.
Conclusion
So which one is right for you? Index funds or stocks? To sum up today’s points:
- Do you prefer a hands-off, set-and-forget method?
- Do you want a lower-risk investment?
- Are you willing to sacrifice extraordinary returns?
If this is you, index funds are the way to go. You can also check out my other post on the three-fund portfolio, an awesome index fund investing strategy.
- Do you want full control over the type of stocks you invest in?
- Are you willing to spend time researching individual stocks and companies?
- Can you stomach high levels of risk?
If this is you, invest in individual stocks.
I hope you’ve found today’s post helpful, thanks for stopping by!