The question comes up often – I’ve even asked it myself – about investing in an index fund or individual stocks. It’s a valid topic and the answer is as personal as what kind of deodorant one chooses. There is no one-size fits all answer. In fact, there’s nothing that says you can’t do both.
Even Warren Buffett suggested that an S&P 500 index fund is best for most people to invest in the stock market. But this blog is dedicated to the pursuit of buying individual stocks. I also know that I can pick a select group of solid companies that fit my needs and goals.
I think this index fund vs. individual stocks is a win-win that gives us all what we want – choice. I’m going to tackle this question like I would in my current job and ask, “What am I solving for?”
In my case, I’m solving for the need to owning quality assets that provide rising dividend income with minimized taxes when my retirement starts in 5 years. That need should almost eliminate the S&P 500 Index since it doesn’t have rising dividend income. If I was looking for more price appreciation then I’d reconsider but the focus is dividend income (with some price appreciation that I don’t get taxed on until I sell).
In this article, I’m going to let you know the reasons I chose individual stocks over an index fund. It doesn’t mean you need to do the same thing but as least you’ll open your mind to the choice. Also, I’m going on the assumption that everyone has already made the decision to invest in the stock market.
S&P 500 Index Fund
Can we agree for this article not to argue about which index fund to use? Since Mr. Buffett mentioned the S&P 500 Index, we’ll use that as our benchmark. And though my Master Stock List is always evolving, let’s use its current state and approach to share my reasoning.
Let’s start the conversation by saying that all stocks in my Master Stock List are in the S&P 500. But for ease of purpose, let’s focus on the Top 50 heaviest weighted stocks in the S&P 500. I’ve highlighted (in yellow) the stocks that are on my list too.
Top 50 Weighted Stocks in The S&P 500 Index
As you can see, there are many similarities when looking at the Top 50 compared to my highlighted Master Stock List stocks. And again, all my listed stocks are in the S&P 500 Index except for my few targeted international companies.
So, if all my stocks are in the S&P 500 Index, why wouldn’t I just buy the index? That’s what I’m going to answer in this article. Again, my reasons are personal to me just like your goals and reasons are personal to you. Make your own choice but I’ll share my reasons. And remember, I’m solving for the need to own quality assets that provide rising dividend income with minimized taxes.
Why I Buy Individual Stocks
Holding high quality stocks that match my needs is my choice for investing in the stock market. With about 5 years left until I retire, I’m building a portfolio that focuses on mostly dividend paying companies. My current (it evolves) Master Stock List is comprised of all S&P 500 companies. Now it’s just a matter of which stocks to choose and when to buy. I don’t chase performance or overpay … I just let the stocks come to me at my accepted price.
Here are my reasons for buying individual stocks based on my needs and goals. You likely have different needs and goals and you’ll have to decide how you choose to invest. Still, I think people of all ages can invest in individual stocks. And as I mentioned earlier, both index funds and individual stocks can be used together based on your unique situation.
I Buy When Prices Are On Sale
Rather than hold stocks from the index with PE’s of 100 or 200, I can buy when the price is right. Patience is key and I’d rather buy something with a PE under 20-25 (depending on the stock). As Warren Buffett says, buy them when they are on the operating table.
I Choose Beta and Sector Weighting
I love Microsoft, Apple, Cisco, Alphabet, Visa, and J.P. Morgan Bank but their betas are higher, and I don’t want to overweight them in my retirement portfolio. Instead, I’ll buy them when they are on sale and with appropriate weighting. Technology and financial stocks make up 30-40% of the index, depending on the year. For these two sectors that rise fast and fall hard, I’d rather not overweight them in my portfolio.
I Don’t Want S&P 500 Junk
There are some junk companies in the S&P 500, and I don’t desire to hold them in my portfolio. They might not be profitable, some struggle with debt, and it’s possible they eliminate/cut their dividend or go bankrupt. I can avoid them altogether when I buy from my quality focused Master Stock List.
I Buy Quality
The companies on my Master Stock List have a history of profitability and are built for long-term success. You can’t say that about several of the stocks in the S&P 500. I’ve made the choice to not own them in my portfolio, so I buy individual stocks. Buying the index fund means I’m owning the good and not so good stocks in the S&P 500.
Lower Fees
Once I buy a stock my fees disappear. Even those fees are next to nothing and I could lower it to zero if desired. Buying an index fund, even at the great Vanguard, will always have fees.
Lower Taxes
Until I sell, my individual stock appreciation isn’t taxed (and I don’t plan to sell). Most index funds average 4-6% of turnover each year and their will be taxes associated with this turnover.
Better Dividend Income
Today, the S&P 500 index is only paying a 2% yield. Since I am building a retirement portfolio, that’s just not enough. If I buy at the right time, most of the stocks I buy will have a yield over 3%+. In 5 years, I hope to generate over $15,000 in dividend income. If I were to buy an index fund, I’d need an index portfolio of $750,000. My individual stock portfolio will only need to be about $425,000.
Summary
Listen, I’ve got index funds in my Vanguard 401k and they work great. But I truly believe owning quality individual dividend (mainly) stocks is a great choice for my situation. Focusing on quality, buy and hold over decades, and buy more on price dips will increase chances of success. Seriously, I think it’s that simple.
I think it’s easier to sell shares of an index fund than selling a stock paying a 5% yield. When you own 300 shares of Exxon Mobil that pay you $1,000 per year it’s hard to sell. How are you going to replace that $1,000? People are hesitant to give up an asset that keeps paying out cash each quarter each year. An index fund finds it difficult to compete on that basis.
I’m not a fan of buying bad companies, overpriced companies, non-dividend paying companies, and be overly weighted to technology and financials. That’s not just an issue for a retiree but for anybody trying to build wealth.
Thanks for reading!
Mr. TLR