If you cannot beat the market, why would you buy individual stocks over index funds?

When I was a broker, most customers did in fact, own solely funds.

Some customers with high net worth or with higher risk tolerances would purchase individual securities they had a good feeling about, but these were typically minor positions.

This is actually a wonderful strategy if you know what you are doing and are willing to put in some maintenance. There were a lot of stories of little old ladies who were secretly millionaires who had repeatedly been writing covered calls against blue chip stocks and letting them expire, then reinvesting the premiums. But most people do not understand how to do that.

The biggest mistake I notice people making is investing in multiple funds with different names and thinking they are diversified. You actually have to look at the prospectus and validate that the funds aren’t investing in the same damn companies.

Some people can actually stay ahead of the market by wise investing. My husband does. However, the general population is better off using mutual funds.

I don’t believe the market is perfectly efficient, in that it’s possible for the market as a whole to under or over value any particular security at any given moment. The trick is to look for strong companies with a good long-term outlook and buy them when the market has a temporarily unfavorable valuation. For example, maybe they’re doing everything right, but there is a temporary drop in demand due to something beyond their control which causes them to fall short of their expected numbers. Or maybe they get hit with an unexpected lawsuit and the price dips even though the company is doing well otherwise. I think of these situations as great buying opportunities. Nothing is guaranteed, and buying individual securities certainly has more risk than the safety offered through the diversity of mutual funds.

I do both. I invest in an S&P500 index fund, and then make bets on individual securities. I have no way of knowing if my success in individual security selection was skill or simply dumb luck, but it has worked well for me in the past. I also think it’s fun because it’s gambling in a game where the odds are in your favor.

Index funds are = by definition – an average. They’re a synthetic collection of a number of different stocks, some of which go down and some of which go up. The theory behind and index fund is that a properly picked set of stocks will reflect the market as a whole, and not be subject to the daily ups and downs of a single stock.

But since the index fund is an average, on any given day any individual stock might shoot up very high (or lose a lot). The index fund blurs those exceptional days by diffusing the action in this average. So you as the investor do not benefit from the positive activity because it was washed out in the average.

Owning individual stocks means that you benefit directly from the ups (and downs) of each and every stock.