Index Funds vs. Individual Stock Investing

Martin writes in:

I’m glad to see you’re writing reviews of books like Payback Time instead of just blindly preaching about index funds. You’ll never make real money with them.

I’m including Martin’s note because he’s actually right: you’ll never be able to beat the market with an index fund.

But that’s not the point of an index fund.

Investment strategies like the one described in Payback Time or Real Money or any other book that describes an investment strategy that focuses on individual stocks have one thing in common. They all require a lot of homework.

Cramer, for example, in his excellent book Real Money (which is far, far superior to his television show) recommends holding at least ten different individual stocks at the absolute minimum to spread out risk – and basically suggests people should hold twenty or more. However, he suggests spending at least one hour per week per stock you own for homework, plus additional time to study stocks not yet in your portfolio. With a twenty stock portfolio, you’re easily approaching thirty hours per week every single week just to study your portfolio.

Some people who are passionate about investing may actually enjoy spending 1,560 hours a year studying their stock picks. Those people, however, are in the minority.

I’m not going to argue that there isn’t some financial gain for that time invested. I absolutely believe that individuals (who are investing relatively small amounts) absolutely can beat the market to a certain degree with significant homework.

The question is whether or not that time is really worth it.

For a person who is passionate about investing, those thousands of hours are enjoyable fun for their spare time. Studying stocks is their hobby – and it’s potentially a lucrative way to mill away the hours instead of consuming other forms of entertainment.

If you haven’t got that passion, though, all of those hours spent doing an appropriate amount of homework are going to seem an awful lot like work on top of the normal workload a person has. It essentially turns your free time into more work time just to squeeze a few more percentage points out of your investment dollars – and that’s if you can execute a good strategy well.

Alternately, people in that position can toss their investment money into index funds, sit back, and simply match the market. You’ll never beat the market, and you’ll likely never beat a focused person who does adequate research into stock picking.

But you also won’t be spending big chunks of your week doing something you don’t really enjoy just to earn a little bit more than you’re already earning.

To me, the answer comes down to this. If you have the passion, make individual stock investing your hobby. Study it. Invest using your research. You’ll be spending your time doing something you enjoy and probably earning some extra cash from it.

If you don’t have that passion, though, stick with index funds. They’ll earn well for you by simply matching the market and let you spend your spare time on something else that you value more.

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  1. Moby Homemaker says:

    Have you ever been to an OTB or racetrack??? These people spend HOURS upon HOURS on researching their BETS. It’s a dedication to their “hobby”.

    I think this article has it right–make investing your “hobby”–like the old guys at the race track. In the end–it’s really the same thing.

  2. J.N.Urbanski says:

    I think, for people who have little time, it’s more important to keep abreast of current affairs that studying historical stock data. Even slight changes in governmental policy can make your stock go into the toilet at a moment’s notice. You can read worthy publications in the doctor’s office or on public transportation, for example. Getting a world view is more important than studying minutiae.

  3. Dangerman says:

    “I absolutely believe that individuals (who are investing relatively small amounts) absolutely can beat the market to a certain degree with significant homework.”

    Although I admit the attempt to find a middle ground, to be reasonable and all, but this statement is scientifically falsifiable. EVERY study of the market shows it to be false: people only outperform to the extent random statistics predict.

  4. Brent says:

    Absolutely with Dangerman. If you actually could (even with lots of homework) beat the market with consistency and in large enough numbers to make it statistically significant. The mutual fund market would be WAY more appealing. Because they don’t work in the relatively small amounts. Any even they can’t beat the average. some of them do, but some lose. The average is just what we would expect. Re balance regularly, dollar cost average, diversify, but don’t think you are any smarter than anyone else out there. You don’t want to be proven wrong.

  5. Sean says:

    Agreed with the previous two.

    You can certainly pick individual stocks that beat the market, but you’re not going to outperform the market after taxes and trading costs; not unless you are willing to take additional risk.

    And if that’s the case, you might as well allocate to an emerging market index fund.

    So it’s nice that you’re being polite to a reader who disagrees with you, but he’s simply wrong.

  6. Daddy Paul says:

    Investing is my passion and I still would never pick individual stocks. I do pick great funds and I do rotate sectors and time the markets.

  7. Caroline says:

    Thanks Trent – I’d started to waver on my conviction to go with index funds, but in truth I hate even reading anything about investments. Even index funds. I love reading about personal finances, but my brain shuts down when it comes to investing.

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