Please ensure Javascript is enabled for purposes of website accessibility

5 Signs You're Ready to Graduate From Index Funds to Hand-Picking Stocks

By Christy Bieber - Mar 1, 2021 at 8:47AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Index funds are a great way to invest, but you can't beat the market with them.

Index funds are a great investment. They track financial indexes, such as the S&P 500, and they make it easy for beginners to build a diversified portfolio while reducing the risk of big losses. They're such a good choice that Warren Buffett, one of the greatest investors of all time, recommends most people make them their primary investment

But index funds are also limiting. While there are many available, all you can do is pick from among them; you don't have direct control over what specific companies your money is invested in. And index funds generally won't outperform the market. They aren't designed to, since they invest your money in lots of different companies. 

If you want to invest in a specific business or take a chance on beating average market returns, you'll have to venture beyond buying funds alone. Before you do that, though, watch for these five signs you're ready to make this big financial move. 

Investor sitting at computer looking at tablet.

Image source: Getty Images.

1. You have an investment account outside your 401(k)

In most cases, 401(k) accounts give you a very limited selection of investment options, and most or all of those are usually index funds.

If you want to buy shares of individual companies, you'll need an account with a broker. This could still be a retirement account, such as an IRA, that allows you to defer taxes on investments. Or you could opt for a taxable account, but make sure you understand the rules regarding how investments are taxed so you don't find yourself with surprise IRS bills.

2. You've thought about your risk tolerance

Investing in stocks is undoubtedly riskier. You're betting on the performance of one company rather than a whole batch of them. You need to be OK with the fact there's a greater chance of losses.

Considering your comfort level with risk is also important for another reason. If you panic-sell anytime share prices fall, it will be impossible to make money. You need to be confident you're comfortable keeping money invested through downturns. 

3. You've developed an asset allocation plan

You probably don't want to put 100% of your spare money into stocks (or index funds, for that matter). And you don't want to invest money in stocks if you'll need the money in the next few years since that could give you too little time to wait out downturns.

Before you invest in stocks, sit down and think about how much of your portfolio you want to devote to buying shares of individual companies. Keep your age and risk tolerance in mind when you make this choice. 

4. You have a plan for building your portfolio

When investing in individual shares of stocks:

  • You need to decide how to build a diversified portfolio. How will you make sure you don't overinvest in a particular company or industry? 
  • You need to understand your goals for investing. Are you looking for reliable dividend income? Stocks that are likely to outperform the market? Or do you simply want to buy some shares of companies you like? 
  • You need to develop an investment strategy. Are you interested in growth or value investing? Are you hoping to day trade, which has extremely high risks and is unlikely to pay off, or become a long-term investor, which has historically been the best approach? 
  • You need to decide how you'll evaluate individual companies. What is your investment thesis? Do you understand how to assess whether a company's share price is worth paying? 

5. You have the time to devote to picking stocks 

Researching individual stocks takes more time than investing in index funds. And you'll want to keep tabs on the companies you've invested in to make sure they maintain the qualities that convinced you they were a good buy in the first place.

If you want to limit your time managing your portfolio, you're better off sticking to index funds, as long as you're OK with the trade-off of limiting potential returns. But if you're excited about taking time to research investment options and build a solid portfolio of stocks, then that's a good sign you're ready to go beyond index funds. 

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/25/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.