You have some money set aside and you've decided it's time to invest. Almost immediately you hit the first big fork in the road: do you buy a fund that tracks the whole market, or do you pick the companies yourself?
Both paths can work. They just ask very different things of you.
What an index fund actually is
An index fund is a single investment that holds every company in a market index, in proportion to its size. When you buy one share of the fund, you own a tiny slice of all of them at once.
That has two big effects. First, no single company can sink you: if one has a terrible year, it's a small part of the whole. Second, you'll never beat the market, because you are the market, minus a small fee.
What picking stocks really involves
Picking stocks means choosing individual companies you believe will grow faster than the rest. Done well, it can beat an index. Done badly, it can lose money even in a year when the market goes up.
It also takes real work:
- Reading company reports and understanding how the business makes money
- Following news that could change the picture
- Deciding when to sell, which is often harder than deciding when to buy
Research such as S&P's long-running SPIVA reports has found that most professionally managed funds trail their benchmark index over long periods. Beating the market is hard, even for full-time experts.
Costs matter more than they look
Index funds are usually cheap to own because nobody is paid to pick stocks. Small yearly fees and trading costs look harmless, but they come out of your returns every single year, and the difference compounds over a long time. Whichever path you choose, check the fees before you buy.
Questions to ask yourself
- How many hours a month do I actually want to spend on this?
- Could I watch one of my stocks drop by a third without panic-selling?
- Am I investing for a goal five, ten or twenty years away?
- Do I enjoy researching companies, or does it feel like homework?
A middle path
You don't have to choose only one. A common approach is to put most of your money in a low-cost index fund and keep a small slice, an amount you could afford to see shrink, for individual stocks you believe in. You get the steady base and still learn how companies work.
Whatever you decide, the most important step is the first one: starting, and staying invested long enough for it to matter.