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.
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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.
