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Deciding Between Stocks and Index Funds? 3 Questions to Ask Yourself

By Christy Bieber – Sep 16, 2020 at 8:30AM

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Answering these investing questions should help you make the right choice.

Investing your money in the stock market is an essential part of building wealth for most people. But you have choices about how to get exposure to equities.

One option is to buy shares of stock in individual companies. Another is to purchase index funds. These funds track various financial indexes, such as the S&P 500, and the goal of the fund is to mimic the performance of the index -- usually by buying shares in all of the companies included in it. 

Deciding between buying stocks and purchasing index funds isn't always easy. When making the call, there are three key questions to ask yourself to pick which investing strategy is the right one for you. 

Investor next to piggy bank with coins in front of it.

Image source: Getty Images.

1. How risk-averse are you?

When you purchase an index fund, you acquire a small stake in each of the components included in the index. Because you'll own a small share of many different assets, your investment provides easy diversification in your holdings and some hedge against losses. Many index funds, such as those tracking the S&P 500, have a very long and consistent track record of producing a positive return on investment over time. So as long as you hold your investment for long enough, it's unlikely you'll experience big investment losses. 

If you buy shares of individual companies, on the other hand, you're putting more of your eggs in one basket. If the specific company you invested in doesn't perform well, the value of your shares could decline -- sometimes dramatically. In fact, it might even be possible to lose almost your entire investment if the business goes bankrupt. 

Of course, you can minimize the risk associated with investing in individual companies by buying shares in multiple different businesses spread across different industries. But since you still won't have spread your money around as widely as with most index funds, the risk still remains higher.

The upside of buying shares of individual companies is that you can often earn way better returns than index funds typically offer -- if you invest wisely. So you're taking a greater risk with this approach, but could potentially be handsomely rewarded. If you're willing to take that chance, investing in stocks is your best bet. 

2. Do you find researching stocks fun?

If you find digging into company financial documents or reading up on new and innovative businesses to be your idea of a great time, investing in individual stocks may be the right approach for you. After all, you're more likely to spend the time to do your investment research right if you enjoy it.

On the other hand, if your eyes glaze over when you read an earnings report or you're not very good at assessing whether companies have a strong competitive advantage or a solid leadership team, index funds may be a better alternative.

Picking index funds can be much easier than selecting stocks since you only need to decide which financial index you want to track, then look for a fund that tracks it and that charges low fees. You won't have to get into the nitty-gritty details of company financials to find a fund likely to perform well. 

3. How much time do you want to spend managing your portfolio? 

When you buy shares of individual companies, you need to make certain you're keeping up with developments that affect their business operations. This takes time. It will also take more time and effort to find new stocks to add to your portfolio when you want to expand your investments or further diversify. 

Index funds, on the other hand, make it possible to essentially set it and forget it. Of course, you'll want to review your holdings occasionally to make sure you have the right amount of money in equities and to ensure your portfolio remains balanced. But you won't need to spend nearly as much time either selecting investments or keeping up with changes to those you already own. 

Again, putting in the time and effort to pick individual stocks can be worth it, but only if you're willing to put in the work. 

Christy Bieber has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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