Assuming you are familiar with the idea of financial independence (FI) and are on your path to pursuing it, you have figured out how to maximize your savings by minimizing expenses and maximizing income. This has allowed you to start accumulating some serious wealth. Now is the time to start thinking about how you would like to start investing your money to help you achieve FI. Remember, you will have achieved FI when your investments produce a steady income source capable of supporting your post-FI lifestyle by itself, allowing you to become work-optional. So, the question is which of these two investment vehicles offers the most efficient path to this point.
Here, we will explore both the fundamentals as well as the pros and cons of each option. I will also explain why one is better than the other for those pursuing FI.
What is an Individual Stock?
A stock is a slice of a company’s assets. When you buy a share of a company’s stock, in essence, you own a part of the company and therefore share in the company’s profits and losses.
Over time, the prices and value of shares rise and fall depending on market movement and the company’s performance. To profit from your investment in individual stocks, you have to be sure you’re investing in companies with good potential for growth and profit. You can take time to study a company’s performance in both the past and present, as well as a number of other parameters to be able to make educated predictions on their future performance.
Pros
- Massive Potential for Greater Returns
Unlike index funds, the performance of individual stocks does not depend on the performance of other companies’ stocks. As such, your chances of seeing greater and quicker gains (and therefore, losses) are higher than when you invest in index funds.
- Flexibility and Control
Investing in individual stocks gives you total control over your investment portfolio. You can decide to invest only in the companies or sectors you trust or combine any number of them.
- Leverage Your Knowledge
Because you can decide where to invest, you can leverage your knowledge of a particular business sector (i.e., technology, healthcare, retail) to make a proper analysis and ensure your choices are the best possible.
Cons
- High Risk Due to High Volatility
The success of your portfolio depends on the performance of the individual stocks. Since a stock’s performance is dependent on many different factors – all of which are out of the control of the investor – they can see high levels of volatility.
- More Difficult to Diversify
Diversifying a portfolio of individual stocks is more difficult as it requires research and understanding of many stocks across several sectors in order to be truly diversified.
What is an Index Fund?
In a nutshell, an index fund is a combination of different individual stocks in a portfolio. It is like a basket of stocks containing shares of different companies in an index.
An index tracks the stock prices and performance of a group of companies with common features. For instance, the S&P 500 index tracks the market capitalization of the supposed 500 largest companies in the US stock market. In addition, some indexes track certain sectors, such as healthcare or information technology.
An index fund holds the stocks of the companies that are tracked by the index. Following our index example above, an S&P 500 index fund will hold the stocks of all the companies in the S&P 500 index. This allows you to invest in all 500 of the largest US companies in just a single transaction.
The performance of the index fund reflects the average performance across all stocks within the index. This protects investors from the volatility they would be exposed to with individual stocks.
Pros
- Diversification of Portfolio
Investing in an index fund is one of the easiest ways to diversify your stock investment portfolio. Instead of buying $500 worth of shares of a single stock, for instance, you can use the same $500 to invest in an index fund that gives you fractions of many other stocks, potentially representing many different sectors.
- Minimal Fees
You may be familiar with mutual funds which are similar to index funds but are instead actively managed by fund managers. These managers constantly research potential stocks and re-allocate the fund’s assets to achieve the greatest returns possible. Because of this, they charge you heavy fees for investing in their fund – something like 2% of your portfolio annually is average. Unlike mutual funds, index funds simply track an index and therefore do not need such active managers. This is why fees for the most popular index funds are as low as .05% – a tiny fraction of the average mutual fund’s fee.
- Passive Investment
Index funds are the closest thing to a truly passive investment. You can just “set and forget” your long-term index fund investment whereas individual stock portfolios require constant research and reallocation overtime to maintain gains and minimize losses.
Cons
- Less Flexibility and Control
When investing in an index fund, you are automatically investing in all the stocks listed in it. As such, you do not have the liberty to choose which stocks to add and which to do away with.
The Winner?
There is rarely a one-size-fits-all solution to a problem in life. This is no exception. Determining which of these options is best for you will rely heavily on your goals and experience. Because you have found your way to this site, however, it is safe to assume that you are interested in pursuing financial independence and that your investment goals will reflect that. This means that you are investing to transform your accumulated assets into a steady stream of income significant enough to support your post-FI income – allowing you to become work-optional. If this is accurate then there is a superior choice: low-cost, broad-based index funds.
For all the reasons listed above, index funds such as NYSEARCA: VOO (S&P 500 index fund) and MUTF: VTSAX (total stock market index fund) have been the investment vehicles of choice for hundreds of thousands of FI-seekers over the past decades. They have historically provided investors with consistent annual growth in the range of 6-8%.
In all, when determining the best investment vehicle between individual stocks and index funds to support financial independence at an early age, index funds will make the most sense for a vast majority of people. This is due to their consistency, diversification, and passivity. While individual stocks may have greater potential for ROI, that greater ROI is rarely achieved and maintained without much research and effort put in overtime. If you would like to learn more, this is a list of some great resources: