Pros and Cons: Index Funds vs. Stocks - SmartAsset (2024)

When you buy shares in a company, you hope that the underlying company will do well and grow the stock price. When you invest inan index fund, you hope that the entire sector of the market that the index tracks will do well and cause all the companies within it to gain value, increasing the value of your index fund investments. That, in a nutshell, is the difference between index funds and stocks. Now let's dive into the details.

Consider working with itFinancial Advisorto find the best mix of individual stocks and index fund holdings for your portfolio.

What is an index fund?

An index fund is a portfolio of assets held and managed by an investment company. In general, it will be largely (or entirely) made from stockcorporate bonds. Just like stocks, you invest in an index fund by purchasing individual stocks. You then own a percentage of the total portfolio that corresponds to the number of shares you have purchased and is entitled to the return of the fund on a pro rata basis.

For example, suppose the ABC fund releases 50% of its value in the form of 100 shares. This means that the company that manages the fund continues to own half of the portfolio. The other half have offered it to investors. If you buy one share in this fund, you will own 0.5% of the total portfolio and be entitled to 0.5% of its return.

This is the basic structure of what is called a fund-based asset, which is what companies typically sellinvestment associationsan ETF's.

An index fund is a specialized form of fund-based asset. With an index fund, the management company selects the portfolio assets to match the index that tracks a specific segment of the market. The idea is that the company ties the performance of its fund to a specific idea, sector, sector or other market measure.

The objective of the fund is to match the return of the index. This contrasts with many fund-based assets, which are built to simply generate returns or reduce risk, regardless of the market as a whole. Unlike other types of assets, an index fund that loses value often performs exactly as intended. For example, a company can build an index fund around ittechnology sector. This means that the fund follows the development of technology shares as a sector. If technology companies do well and gain value, the index fund will also gain value. If tech companies hit a rough patch and their prices fall, the value of the index fund will fall – by design.

To do this, the company managing an index fund will build its portfolio with assets that are relevant to the performance of its chosen benchmark. For example, a company building an index fund for the technology sector might build a portfolio of stocks of technology companies, bonds issued by technology companies, and other assets that it believes reflect the performance of the technology sector as a whole. Depending on the fund, this company can e.g. buy options contracts in gold, silicon and other semiconductors. Or it could invest in logistics companies known to work closely with technology companies.

The exact makeup of an index fund is up to the company that manages the fund, and investment firms work very hard to create the right formulas for an index fund that succeeds in tracking the value of its sector. However, the general principle is consistent: an index fund is made up of assets that the company believes represent the value of a market segment.

The most popular index funds track large parts of the market. This includes in particular:

How index funds differ from stocks

There is now a sharean ownership interestin an individual company. By purchasing a stock, you have literally purchased a share of ownership in the underlying company. For example, let's say a company releases its entire value for sale in 100 shares. If you buy one share of the company's stock, you now own 1% of the company itself. Depending on how the company manages its shares, this may entitle you to a share of the company's profitsform of dividend. It may also entitle you to a vote on the company's board, depending on the number of shares you own. (Of course, given that large companies can issue billions of shares, it takes a significant investment before you can have a meaningful voice in the businessa listed company.)

You usually earn on a share through what is calledcapital gains. If the company does well, other investors will be interested in it. This increases the demand for the company's stock, which in turn increases its price in the market. If the price rises while you hold the stock, you can sell your shares for more than you paid to buy them, making a profit. Stocks can also provide returns in the form of dividends, when the company pays its shareholders a portion of the company's profits.

Regardless of the details, with a stock you ultimately make your money from the performance of one company.

Index funds vs. shares

The biggest difference between investing in index funds and investing in stocks is risk.

Individual stocks tend to be much more volatile than fund-based products, including index funds. This may mean a greater chance of winning... but it also means a significantly greater chance of losing. In contrast, the diversified nature of an index fund usually means that its performance has far fewer peaks and valleys. Like all fund-based products, an index fund has a large number of different assets in its overall portfolio. Instead of investing in just one stock, as you would with stocks, you invest in dozens (if not hundreds) of stocks, bondsand other assets.

This means that even if a company loses value, there is usually another company to take care of that performance. If a company makes big profits, those returns will obviously be diluted by the rest of the portfolio as a whole.

The diversification of an index fund depends on the nature of the fund itself. A fund that invests in a particular industry or market sector will be less diverse than a fund that invests in the market as a whole. For example, you can invest in a technology sector index fund and an S&P 500 index fund. It's easier for something (good or bad) to happen to the tech sector specifically than for something to happen (again, good or bad) to the entire stock market.

An industry can fall or boom more easily than the entire market can fall into recession or rise.

The advantages of the index fund

For an individual investor, index funds generally have two major advantages over investing in individual stocks. First of all, ignore what some other financial websites have written about taking control of your assets and the personal satisfaction of financial success. Few investors have ever beaten the market. This is true even among professionals. Research consistently shows that more than 90% of professional investors cannot pick stocks that outperform the market as a whole over the long term.

Tag toinvestment portfolios. Put nothing but an S&P 500 index fund in one, and actively buy and sell stocks in the other. Your index fund will almost always be worth more year after year. This isn't a cast-iron rule, but nine times out of ten you will make more money with index funds.

Second, an index fund reduces complexity. Investing in the stock market means tracking performance, following company fundamentals, reading earnings statements and much, much more. This is difficult to do well, and it can quickly consume your time and attention. Investing in an index fund is one of thempassive investment strategy. You buy the asset and leave it alone to accumulate value and generate returns. There is no need to track performance or play the stock market.

It is not unwise to invest in shares. Many investors even enjoy active investing. They believe that trying to beat the market is a thrill. But as with all speculative assets, you should make sure that individual stocks make up only the speculative portion of your portfolio. Invest in these assets with money you can afford to lose. For the long-term stable part of your portfolio, index funds are often an excellent idea.

In short

A stock gives you one share of ownership in one company. An index fund is a portfolio of assets that typically includes stocks of many companies, as well as bonds and other assets. This portfolio is designed to track entire segments of the market, rising and falling as those segments do.

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