One of the first decisions when you start investing is whether to buy individual stocks of specific companies or channel your savings through diversified investment funds. It isn't an all-or-nothing decision, but it's worth understanding the implications of each approach.
Diversification: the most relevant difference
An investment fund (especially one indexed to a broad index) gives you exposure to hundreds or thousands of companies with a single transaction, diluting the specific risk of any individual company. Buying individual stocks, unless you acquire a very large number of them, concentrates your risk in a small number of specific companies.
The time and knowledge each approach requires
Selecting individual stocks in an informed way requires analyzing each company's fundamentals (results, debt, competition, sector outlook), a process that takes time, knowledge, and constant updating. Investing in index funds, by contrast, doesn't require that individual analysis, since you're tracking the aggregate performance of the chosen market or sector.
The evidence on individual active management
Numerous long-term studies show that a large majority of individual investors (and even professional managers) fail to consistently beat the return of benchmark indices once fees and time invested are accounted for, which has driven the growth of index investing as the preferred alternative for a large share of individual investors.
When it can make sense to combine both approaches
A common strategy among more experienced investors is to put most of their portfolio into low-cost diversified funds, reserving a smaller portion (sometimes called a "satellite") for specific individual stocks they have particular conviction in, accepting that this component carries higher risk and potential volatility.
Taxation also differs in one important respect
Investment funds allow you to switch between funds without being taxed at the time of the switch, an advantage individual stocks don't have, where every sale triggers an immediate taxable event, regardless of whether you reinvest the proceeds in a different stock.
There's no universal answer, it depends on your profile
If you prefer simple, diversified, low-maintenance management, index funds tend to be the most sensible choice for most individual investors. If you have the time, interest, and enough knowledge to analyze individual companies, and you accept the added concentration risk, individual stocks can be part of your strategy, ideally as a complement rather than the sole basis.
Simulate the effect of your chosen strategy
Our compound interest calculator lets you project your investment's result under different average return assumptions, regardless of the specific approach you choose.