Picking stocks vs index funds. What’s the best investment strategy?

Over the last decade, index funds have changed the way people invest in the stock market. Are they a better idea than picking stocks yourself though?

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Stock market investing has changed dramatically over the last decade or so. Not so long ago, if you wanted to invest in stocks, your two main options were picking them yourself, or investing through a mutual fund and paying a portfolio manager high fees. Stock picking was popular because it eliminated fund manager fees.

However, the rise of exchange-traded funds (ETFs), or index/tracker funds, in recent years has completely changed investing. Through an ETF, you can get exposure to a whole market or index with just one security at a very low cost.

Is investing through an ETF a better idea than picking stocks though? Let’s take a look at each strategy.

Index investing

ETFs offer investors a number of benefits. For a start, they make investing a very simple process. Through just one security, you can get exposure to a whole index, whether that’s the FTSE 100, the S&P 500, or the China Shanghai Composite index. Given that it’s very hard to consistently beat the market, buying the market itself through an index fund makes a lot of sense.

The other main advantage of tracker funds is their cost structure – fees are generally very low. For example, through online broker Hargreaves Lansdown, you can invest in the Legal & General UK Index fund – which tracks the FTSE All-Share index – for just 0.04% per year. Keeping your fees low is important when investing in the stock market, so tracker funds have considerable appeal from a cost perspective.

On the downside, however, index funds provide you with very little flexibility as you’re forced to own every stock in the index you’re tracking. Not a fan of companies that manufacture weapons? If you own a FTSE 100 or S&P 500 tracker, you’ll have exposure to them.

The other drawback of index funds is that, by definition, you will never ever beat the market. That may not be an issue when the market is rising, but what about if the market is falling, or trades sideways for a decade?

Picking stocks

Stock picking also has its pros and cons. One of the big advantages of picking your own stocks is that it gives you flexibility. If you want to construct a portfolio that has a higher yield than the index, you can. If you want to avoid tobacco stocks for ethical reasons, that’s easily done. When you’re picking your own stocks you have far more control over your portfolio.

Picking your own stocks also provides the potential to generate life-changing returns. For example, had you invested $5,000 in Amazon a decade ago, that investment would now be worth around $114,000. Of course, not every stock performs this well, but the point is you’re not going to get those kinds of returns from index investing.

On the downside, stock picking does require time and effort. It takes time to thoroughly research companies, and you need to have a basic understanding of investing as well.

Ultimately, both strategies have their advantages and disadvantages. If you don’t have much of an interest in investing and you’re simply looking for exposure to the market at a low cost, an index fund could be a great choice. On the other hand, if stocks do interest you, and you think you could potentially beat the market, stock picking could be a good option.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Edward Sheldon owns shares in Hargreaves Lansdown. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool UK owns shares of and has recommended Amazon. The Motley Fool UK has recommended Hargreaves Lansdown. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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