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Index Funds vs. Stocks: We Need to Talk About Investor Behavior

Today’s investor has a lot of options for investing money. Index funds vs. stocks vs. bonds vs. alternative currencies. The list goes on.

With lots of research confirming the superiority of stocks over dividends for the very long term, many investors are approaching the stock market but in very different ways.

indexing

Many books, experts, and financial advisors recommend buying index funds (through ETFs) rather than trying to pick individual stocks. However, the behavior of the average investor has suggested a different view– with the many resources and services available out there to support an investor trying to pick stocks.

Both methods have pros and cons.

Indexing is relatively new to the world of investing while the ability to buy individual stocks has been around since the before the 1900s.

In this blog post about index funds vs. stocks, I’ll briefly introduce what an index fund/ ETF is, and talk about what makes it distinct from individual stocks. I’ll talk about why indexing is a common recommendation for the average investor.

I’ll highlight some of the emails I’ve received from readers, who know I advocate picking stocks and challenge that viewpoint. Finally, I’ll get to the crux of the issue and take a deep dive to consider which approach can give the most optimal returns and if it is feasible for the average investor.

What’s an Index Fund?

Much like a mutual fund, an index fund is a basket of stocks grouped together that an investor can purchase outright. This is commonly done through an ETF.

The most common index fund is a market index ETF like ticker symbol $SPY, which holds a basket of all of the stocks in the market (commonly defined as the S&P 500). Instead of an investor having to buy all 500 stocks of the market individually, the investor can purchase an index fund comprised of all 500 stocks.

This has multiple benefits. 

For one, the average investor (especially a beginner) probably doesn’t have enough capital to buy at least 1 share of each of the 500 stocks that make up the S&P. You have wide ranges of stock prices inside of the S&P 500, and it’d be difficult to assemble a balance portfolio of these.

A market ETF, on the other hand, can usually be purchased with a couple hundred dollars– and you get the same exposure as-if you had purchased each stock individually.

As the S&P 500 index moves up and down, so does the price of 1 share of the index fund. It’s quite easy to track the performance of an index ETF, as the S&P index is widely covered by basically all financial media sources.

The second benefit of indexing comes from the same first one.

An investor doesn’t have to pick stocks, so there’s no differentiating between winners and losers.This is helpful because it obviously saves time. An investor can worry less about being wrong (assuming a good understanding of the stock market’s behavior historically). There’s also research about most active fund managers being more wrong than right, suggesting that picking stocks successfully is impossible.

Finally, you pretty much know what you’re going to get with an index fund. You won’t beat the market, but you also won’t underperform the market. You’ll get the same returns as the overall stock market, because you own the whole stock market through the ETF.

With lots of research indicating that the average long term annual return from the stock market is around 10% (7% after inflation), an investor who indexes can reasonably expect those type of returns over the long term.

Book Supporting Indexing: A Random Walk

Now, many very intelligent investors and advisors recognize the great benefits described above and prescribe them as the best solution for the average investor. I want to highlight some of those resources, and then discuss why I believe better results can be achieved for those wanting to try picking individual stocks.

Here’s some of those books that support indexing in the index funds vs. stocks debate, as shared by my audience through emails to me:

“Hi Andrew,

I’ve been listening to your podcast for about two months and have really enjoyed it. I have learned so much about the stock market and have actually built the confidence to buy my first stocks. Something that seemed very confusing a couple months ago is now a lot less intimidating and understandable.

I have started some of your reading recommendations. I finished The Richest Man in Babylon last week and felt motivated enough to run through a wall after it. It was definitely a great recommendation.

I am now about halfway through Burton Malkiel’s A Random Walk Down Wall Street. I am finding this very interesting as well as it has a lot of advice surrounding wealth building in general.

What I was wondering was why do you disagree with his ultimate suggestion of index funds so much. He seems to site many reasons why just betting on the average is clearly the safest way to go. He gives multiple examples as to how you can basically build a fortune by passively investing in a broad index fund and taking advantage of dollar cost averaging.

I’ve listened to just about every episode of the podcast but cannot remember if you really elaborated on this. I can completely see how finding your own stock may be more rewarding and may also have a better chance at getting above average returns, but you also run into a lot more risks.

Keep up the great work. I really enjoy the show and hope to learn a lot more from you guys.

Thank you,
Nick”

You’re right that buying index funds is a safe thing to do. However, I’m all about maximizing returns by reinvesting dividends.

Index Funds Con #1: Dividends

Look at the dividend history of $SPY (the S&P 500 ETF). You’ll see that it’s never consistent, it goes up and down with the economy.

Contrast that to great dividend payers. They increase their dividend for consecutive years, whether the economy is booming or not. Because they make this reputation for themselves, they try really hard to keep those consecutive streaks intact. It attracts investors.

Those steady increasing payments create a compounding effect alongside the compounding you get from the share price and from reinvesting dividends to buy more shares.

Stocks without track records of increasing dividend payments probably won’t care too much about cutting their dividend, and many stocks in the S&P 500 don’t pay a dividend at all.

That means that when you’re buying an index fund, you’re likely not receiving the maximum compounding possible from dividends compared to buying a group of great dividend payers.

Index Funds Con #2: Valuation

An index is weighted. That means that stocks that are bigger affect the index more than the smaller ones do.

For example, Apple has $800B+ market cap. Chipotle has about $9B. If $AAPL were to drop 10%, this would drop the total index price by much more than a -10% drop from Chipotle would.

So, what do you think happens to the overvalued (bubble) stocks as a bull market goes on?

They take up more and more of the index… pricing it to fail.

Now you can certainly buy equally weighted ETF indexes. But the problem remains of getting a heavy mix of overvalued bubble stocks in there.

If you can learn how to avoid overvalued stocks and instead buy undervalued stocks– stocks more statistically likely to do better– then you can avoid much of the “bubble pop”. The higher a valuation rises, the harder a stock tends to fall.

Book Supporting Indexing: The Intelligent Investor

One of the most popular advocate of picking stocks was Benjamin Graham. He was considered the “father of value investing”, was Warren Buffett’s mentor, and wrote several books on the subject of analyzing individual stocks.

In his own book that’s still a bestseller today, The Intelligent Investor, the recommendation for investors to just pick an index fund is there as well.

From podcast listener Mike:

Good morning Andrew,

Just going to make this short and sweet.

I’ve picked up a lot of the books that have been mentioned on your podcast. I’ve read the little book that’s beaten the market, rich dad poor dad.

And am on chapter 13 of intelligent investor (tough read I might add but have picked up a lot).

Now I have always planned on buying your VTI package after I get through all the books I’ve purchased.

But as I am reading through the intelligent investor they keep advising to invest in index funds. I’m curious why you didn’t invest in index funds and rather choose to invest in stocks?

As I continue to read I am feeling myself lean towards investing in index funds.

Looking forward to your response,
Happy Monday.

Let’s just clarify a couple of things. The version of The Intelligent Investor that is sold in stores these days includes commentary from Jason Zweig, a well known Wall Street guy. So some of what’s in there isn’t straight from Ben Graham’s mouth.

What Graham does say is that most investors should invest in index funds. In the book, Graham outlines several types of investors.

Passive, active, defensive, enterprising… He says most people should be passive and defensive.

Index Funds Con #3: Investor Behavior

Here’s a problem I see with that. Hearing that you should “just index” can be a buzzkill and assumes that that’s all you need to know. When in reality, there’s much more to learn about the stock market and investing rather than “just index”.

Learning about indexing should be just the start of an investor’s journey to educate themselves.

What an investor also needs to understand is the common behavior of the stock market over the long term, and the necessity of bull and bear market cycles. The investor doesn’t need to just know this, the investor needs to master this– so that during a bear market there’s no urge to sell.

An investor who doesn’t fully grasp the workings of the stock market probably won’t behave correctly when adversity strikes, which is devastating to overall returns. The time when the biggest returns are made in the stock market is during the recovery after a tough crash and/or bear market. It’s basically impossible to time, and requires just staying invested throughout the whole time.

An investor who was just told to index but doesn’t understand why is likely to see his portfolio losing value everyday and question himself constantly on if he should stop the carnage and sell.

index funds vs. stocks

Instead, you can engage with the stock market by making financial education a priority. Why do we focus on our careers so much and worry about the difference between a 3% vs 4% raise when a difference between 8% and 10% returns a year can have a much bigger impact on our overall financial picture?

Investing should be a part of one’s life and is a part of one’s life for the rest of one’s life.

In my opinion, knowing that there are bigger and better returns possible by picking individual stocks fires me up and motivates me to learn more about the stock market. It’s cemented into my brain that the values of my portfolio now don’t matter, but it’s that value in 20, 30, and 40 years.

And that’s where individual stocks can hold an advantage over index funds, because it can inspire behavior that wouldn’t be there for someone who just blindly indexes without really understanding what they’re getting into.

It’s through the journey of knowledge that you’ll master the concepts of dollar cost averaging, diversification, and buying and holding for the long term.

That journey of knowledge needs to be made at some point of your life if you really want establish the behaviors habits to assist you in making the most optimal decisions for your money. Money is a huge part of our lives, yet most people won’t even crack open a book to learn how to properly utilize it.

Why are personal trainers so popular these days? Is it because people don’t understand that lifting weights will build muscle and that a good diet will help you lose weight?

No, people know these things… but their behavior clearly shows they haven’t mastered them.

People hire personal trainers to motivate them, to help them fix the behaviors and habits that will lead to long term results. And that’s exactly what the process of trying to pick individual stocks can do for you.

When you have a reason to learn about the stock market, when you see what others have done and start to see outsized success in your portfolio, it becomes hard NOT to want to learn all you can about investing and do whatever it takes to save more and invest more.

I really believe so many people can do so much more with their money. And emulating the greats like Warren Buffett and Benjamin Graham can be such a great way to get started.

Graham averaged a return of 17% a year during his time as a fund manager. Using a compound interest calculator to compare those results to the 10% market average, the differences are astounding (in 40 years, $10,000 –> $5.3 million at 17%/yr vs. $452k at 10%). That’s massive. If you want to try a similar approach as Graham’s, you’re gonna want to learn about value investing and buying with a margin of safety.

If you think you really understand the market and don’t want to take the effort to learn more, then I think you definitely be what Graham called a passive and defensive investor, and just buy index funds.

But if you take that path and end up stressing about where the market is going, or finding that your behavior isn’t leading to the results you want, then I really challenge you to reconsider and challenge yourself to learn.

“To become a master at any skill, it takes the total effort of your: heart, mind, and soul working together in tandem.”
― Maurice Young

That includes your money, people.