Index funds vs picking stocks: the plain facts
Index funds buy a whole market. Stock pickers try to beat it. Here is how the two approaches compare on cost, risk, effort and results.
There are two broad ways to own stocks. You can buy a fund that holds a whole market, or you can choose individual companies yourself. This guide sets out how they differ, without telling you which to pick.
What an index fund is
An index fund holds all, or nearly all, of the companies in an index, such as the S&P 500 or the S&P/TSX Composite. Its aim is to match the market, not beat it.
Index funds come as mutual funds or as ETFs, which trade on a stock exchange like a share.
What picking stocks means
Picking stocks means choosing the companies you think will do best. You might do it yourself, or pay a fund manager to do it. A fund run this way is called an actively managed fund.
Cost
Index funds are usually cheap to run. There is no team of analysts choosing stocks, so yearly fees are often very low.
Actively managed funds charge more to pay for research. Buying single stocks yourself has no yearly fee, but trading commissions can add up.
Fees matter more than they look. They come out every year, whether the fund does well or not. In Canada, a fund's yearly cost is shown as its MER, or management expense ratio. In the US it is called the expense ratio.
Risk
An index fund spreads your money across hundreds of companies. If one fails, it barely matters.
A handful of single stocks is much riskier. One bad result can cut a share's value sharply, and some companies go to zero.
Results
Beating the market is hard. S&P Dow Jones Indices publishes long-running studies, known as SPIVA reports, comparing active funds with their benchmark indexes. They have consistently found that most actively managed funds trail their index over long periods, often after fees.
Some stock pickers do beat the market. The difficulty is knowing in advance who they will be.
Effort
An index fund needs little work once you own it. Picking stocks well takes time: reading earnings reports, following news and judging value.
Not all or nothing
Many people combine the two. They hold an index fund as the core of their savings and a smaller amount in companies they have chosen.
The short version
- Index funds aim to match the market. Stock picking aims to beat it.
- Index funds are usually cheaper and spread risk across many companies.
- Most actively managed funds have trailed their index over long periods.
- Picking stocks takes more time and carries more risk from any one company.
This is general information, not investment advice.
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