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Are Individual Stocks or Index Funds the Better Investment?

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Friday, 05 October 2018 03:17 PM Current | Bio | Archive

There is a big debate going on in the investment world right now between passive and active investing. Those who favor passive investing typically purchase index funds, while more active investors might prefer to invest in individual stocks.

There are good reasons for both strategies. Each has its own advantages and disadvantages, which is why the best way to go might be for investors to utilize a mix of both.

Ultimately, the optimal mix of active versus passive investing depends on the specific goals and risk tolerances of the investor.

What Are Index Funds?

Index funds are the quickest and easiest way to gain broad exposure to a specific sector or market index. Index funds hold a basket of stocks, which provides investors with instant diversification. For example, the SPDR S&P 500 Trust ETF (SPY) seeks to replicate the returns of the S&P 500 Index, the most common stock market index. There are many other index funds investors can select from. The spectrum of index funds spans entire indexes like the S&P 500 or the Nasdaq, as well as sector-specific funds. Investors can purchase equity index funds that track a certain sector of the market, such as technology, consumer staples, or health care.

The appeal of buying index funds instead of individual stocks, is simplicity and reduced volatility. The SPDR Index Fund provides a one-stop shop for instant access to the S&P 500 Index. To buy individual stocks, investors need to devote a significant amount of time to researching company fundamentals, stock valuation, and a number of other important topics. For those who simply do not want to spend their time reading through company financial reports, buying index funds is likely the better investment strategy. However, while buying individual stocks is a more time-intensive endeavor, there are potential rewards for the extra work.

Reasons For Buying Individual Stocks

The major downside of index funds is that ultimately, investors will not outperform the indexes over time. For example, if an investor buys the SPDR Index Fund, he or she will earn the market return, minus annual expenses levied by the fund sponsor. The allure of buying individual stocks is that, if the investor is particularly skilled, he or she could outperform the market. This is not easy to do, which is why many investors prefer to utilize index funds.

In addition to investors looking to beat the market, income investors might also prefer to buy individual stocks. Most balanced index funds based on the S&P 500 Index have a fairly low dividend yield. The continuous market rally over the past 10 years have caused dividend yields to fall across the market. Today, the S&P 500 Index has an average dividend yield of 1.7%, meaning the average dividend stock in the major market index yields well below 2% right now.

This could be a fairly unappealing yield for income investors such as retirees, who might desire higher levels of investment income. Therefore, constructing a portfolio of individual stocks with significantly higher dividend yields than the S&P 500 Index, could be the more attractive option for income investors. There are a number of high-quality stocks that have above-average dividend yields. For example, the Dividend Aristocrats is a group of 53 stocks in the S&P 500 that have increased their dividends for 25+ consecutive years.

AT&T (T), Exxon Mobil (XOM), and Procter & Gamble (PG), are just a few examples of strong companies that most investors are probably familiar with. And, they all happen to be Dividend Aristocrats. Not only do these stocks raise their dividends each year, they also reward shareholders with high dividend yields. AT&T, Exxon, and P&G have current dividend yields of 5.9%, 3.8%, and 3.5%, respectively. Weighted equally, these three stocks provide an average dividend yield of 4.4%--more than double the average dividend yield of the S&P 500 Index.

While buying individual stocks exposes investors to single-stock risk, investors can mitigate this risk by creating a diverse stock portfolio. Investors can also reduce portfolio volatility, even with individual stocks. AT&T, Exxon, and P&G all have beta values below 1.0, which means they can be expected to be less volatile than the S&P 500 Index.

Final Thoughts

The debate between active and passive investing strategies continues, but investors do not have to pick one side or the other. There is room for both active and passive investing, as both strategies have advantages. The decision may come down to the specific goals of the individual investor.

Ben Reynolds is CEO of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth stock portfolios for the long run.
 

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BenReynolds
The debate between active and passive investing strategies continues, but investors do not have to pick one side or the other. There is room for both active and passive investing, as both strategies have advantages. The decision may come down to the specific goals of the individual investor.
individual, stocks, index, funds, investment
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2018-17-05
Friday, 05 October 2018 03:17 PM
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