Here’s the latest post in the Rockstar Finance Money Match-Up series where two money bloggers argue opposite sides of an issue.

Today’s issue features a debate that’s quite the rage these days — which is better, investing in index funds or picking your own stocks?

We’ll begin with Alexander Voigt from Daytradingz who thinks index funds are the right choice…

Why index funds are the better choice compared to individual stocks

Savings accounts and time deposits are currently not very profitable, that much is obvious. Looking back over the period since the 2008/2009 financial crisis, it is easy to see that the capital markets performed significantly better.

As for the comparison between investing in equity funds versus investing in individual stocks, both types of investments have their advantages and benefits, but also specific disadvantages that you should know before making any decision. I prefer investing in index funds. Why? You will find out in this article.

Running Costs

Shares:

Those who regularly buy and sell shares accumulate costs with each purchase and sale. The broker and the stock exchange take fees that in the long term can add up. To meet the need for diversification, more individual stocks must be bought and sold than is necessary for example with an index fund. And over time, the depot must be regularly rearranged. The investor is responsible for this redeployment.

Index Funds:

Those who invest in index funds can relax. The investor usually selects a highly diversified fund, such as the MSCI world. The MSCI world fund contains hundreds of companies in which the investor holds a small stake. The fund company takes over the restructuring. The investor is not required to do anything, but pays a management fee to the fund company. It is certainly important to choose a fund with very good cost structures, best an ETF.

Summary: A standoff – as both investments incur costs. Depending on investment volume and diversification, investing in equities can be significantly more costly than investing in index funds.

Transparency

Shares:

Investing in individual shares comes with the opportunity to view the annual reports of the individual companies in detail, to evaluate them and to decide how and whether to invest based on business performance. Besides, one might attend the annual general meeting of a company. Since, depending on the accounting, there is not always 100% transparency, the value of the information is questionable, because not all key performance numbers can be compared between companies. Accounting rules often leave room for maneuver, which then has to be interpreted.

Index Funds:

When investing in index funds, it makes no sense to view annual reports of the individual stocks listed in the fund. Why? Because as an investor in index funds, you have no decision-making power over which shares are or are not included in the fund. On the other hand you cannot make a mistaken decision based on company figures.

Summary: Investing in index funds is one step ahead, unless attendance at the AGM is particularly important to an investor. This participation is possible only for shareholders, not for the owners of shares by funds.

Expenditure of Time

Shares:

You have to analyze and select stocks yourself. With a short or medium-term investment horizon you’ll have to invest a lot of time, to examine stocks regularly, to observe prices and markets, to make purchases or sales etc. Whenever an investor makes a negative experience with a particular share the psychological aspect is added. Suddenly, every single investment takes disproportionately long time or mistaken decisions affect the entire portfolio. The expenditure of time is high from the first, but can get very much higher. In the course of one month this may mean not just hours, but days spent on activities that are related to the investment. With shares, the odds are that you’ll worry more about the deposit because you can exert more influence and buy and sell individual assets.

Index Funds:

The decision to invest in a fund is usually made by the investor at the beginning. From then on, he lets his investment work on its own, or he benefits from it, for example with a monthly savings plan. If an investor chooses to continue diversifying into funds, a second or third fund may be added. But not more. For example, the deposit of a typical index fund investor often consists of the MSCI world, MSCI emerging markets and perhaps even a small proportion in commodities. If the portfolio consists of several funds rebalancing will be carried out once a year if necessary, and that’s about it. More is not necessary. The psychological tie is also small. “Buy and forget about it” is the motto. The management is done by others.

Summary: Investing in Index Funds is a clear winner in terms of time expenditure.

Why are index funds the first choice?

If you want to make long term investments it is a good idea to spend as little time as possible on your assets. It has been statistically proven that the average investor who invests in individual stocks performs just as well as an index. Of course, there are investors who achieve a significantly better return than the market with a single-share deposit. But there are also investors who are doing really badly.

So if on the one hand the performance and the costs are similar on average and on the other hand, the temporal bond and the psychological burden are lower, we have a clear favorite.

The winner is: investing in Index Funds!

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Now let’s hear from Michael Dinich at Your Money Geek who thinks picking stocks is superior…

Indexing vs. Stock Picking

The blanket statement that indexing works in every situation can be misleading, and may leave investors upside-down. Before determining what financial strategy is most effective for you and your goals, you need to understand all of the pros and cons associated with your decision.

Before we all jump on the indexing bandwagon we need to consider there is a reason that individual stocks and even active management have remained common despite the growing popularity of indexing. Despite the beliefs of some journalists and bloggers, financial advisors and the financial services cartel are not in league with the illuminati to deny the investing public the opportunity to buy dirt cheap investments.

Not every investor’s goal is to get from financial point A to financial point B as cheaply as possible. An investor may choose, comfort, security, guarantees, or even excitement over cost.

Everyone’s financial situation is different, and each requires a different financial strategy to best meet your goals. If the majority of the financial advice you hear promotes passive investing and indexing, it doesn’t necessarily mean that it’s right for you or that it’s the correct choice.

So, let’s discuss why indexing may not always work for you:

Your business’s value or income is highly correlated to the business cycle or the market

Investors may own assets such as a business that’s very cyclical in nature. The business may represent a large portion of their net worth. Investing in an index such as the S&P 500 may not provide enough economic diversification.

Let’s say you are in B2B sales, such as advertising, and you sell to Fortune 500 companies. If the Fortune 500 companies are no cutting back on spending due to a recession or market downturn, the business owner may take a hit in income? If their investments are tied up in the S&P 500 the same downturn or recession that hurt their business bottom line could also hurt their investment portfolio. Seems to be a lose-lose situation.

You have a cause or value that you prioritize

Do you have a cause or value that you prioritize? Is there something that you’re passionate about and therefore must be applied to your investment strategy? Maybe you want to invest in green initiatives; maybe you don’t want “dirty” banks getting your cash; or maybe you have religious objections.

People make decisions based on emotions and altruistic beliefs, and not always grounded in the economics. One may be that people like to invest in companies and missions which align with their own values. Now, before you point out that there’s an index for social responsibility, let me point out that I’ve been down that rabbit hole before. The more specialized the index, the less the index behaves like passive management and the more it behaves like active management investing, like mutual funds/ETFs.

The individuals picking the stocks for the index are forced to make qualitative decisions about how well a company compares to the index’s mandate. An individual investor may disagree, as corporate responsibility is subjective.

Some people prefer to invest in companies they know and understand. Additionally, they may not be comfortable with the valuations the markets are putting on specific companies. In recent times, we have witnessed indexes that were heavily affected by the over-performance or under-performance of a few select companies. Indexing can’t possibly yield positive results by being extreme.

You are a participant in an employee stock ownership program and can’t access your funds

If the bulk of your retirement savings is in one stock, it may be highly correlated to an index, example being P&G. An investor may work for a corporation that offers stock options, stock ownership, profit sharing, or a pension that’s heavily invested in its own stock. If this employer is a major component or highly correlated to the index, the index may not offer an appropriate amount of diversification.

Let’s say an investor has 1.1 million dollars in P&G stock; however, he can’t touch it until he retires. How does investing his $200,000 IRA in an S&P 500 fund at Vanguard give him the diversification he seeks? (P&G Stock and the S&P 500 are highly correlated) He may need to explore other options to limit the volatility of his large amount of stock.

This is why diversification in your asset allocation is so important. It helps lower your risk. Some think that indexing is diversification. They are mistaken. If you want to truly diversify you need a combination of stocks, bonds, asset investments like real estate, etc. The premise behind diversification is to buy assets that are not highly correlated or even correlated at all.

Various pricing opportunities

Individual stocks may offer pricing opportunities not present in the index overall. While I am not suggesting day trading, there may be times that purchasing individual stocks on an impromptu basis would be beneficial. After all, wouldn’t everyone consider a great opportunity when it presents itself?

Many companies have bad news days, and these can represent an opportunity. This opportunity need not be overly risky, many times call and put options (used to minimize risk) are less expensive on individual stocks than on the index and downside hedging, is possible.

An investor who may be seeking income may find that a basket of individually selected stocks offers a more consistent or higher-yielding dividends. Also, option chains may be lower cost, and an investor seeking to use options to enhance income may benefit from hand selection

The Bottom Line

Research suggests that many active fund managers underperform their respective benchmark. Even with the popularity and accessibility with indexing, research also suggests that most investors underperform not only the underperform index but also active management.

Clearly, there is a non-economic psychological force at play. Some of the investors that are underperforming may be getting financial products that do not align with their goals. This is always a recipe for disaster no matter how well liked or rated the product is. Investors need to consider what will work for them.

Indexing is not the only way to invest your money! Be cautious of where you obtain your information from, and do your research before proceeding with investment advice. Not all financial advice works for everyone. Indexing may work in some cases, but it is not the end-all, be-all. Financial advice comes in all shapes and sizes. You have to determine what will work best in order for you to achieve your financial goals and give you peace of mind in the process.

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So, those are the two sides of the issue. What do you think?