I want to make this clear from the beginning. I am not advocating investing just in individual stocks instead of index funds. I am talking about investing in individual stocks in addition to investing in index funds. I want to make this argument because I feel that as individuals who interact with so many public companies, we have an edge over institutional investors and we are more in tune with some of the latest products and technologies in our everyday lives. Think about the products that delight you, and then ask yourselves what are the companies behind those products.
I have been investing in the stock market since 2006 primarily through my 403B and 401K accounts in index funds. I started investing a small amount in individual stocks in 2012 in my taxable brokerage account and have been investing in individual stocks since then. Here is how I have done in both these strategies.
The index fund portfolio has almost tripled in 14 years, but the individual stock portfolio has almost quadrupled in eight years. I have been adding new money to both these portfolios on a consistent basis every year.
I couldn’t believe the outperformance of individual stocks over index funds when I compared the returns of both my portfolios. These are the results of mostly a buy-and-hold portfolio. I have never engaged in day trading, nor bought any stocks on margin, nor shorted any stocks, never bought any penny stocks. I don’t like to brag but I wouldn’t be able to make this point without a little bit of bragging. I have made all kinds of mistakes that you can imagine, buying hype stocks, buying at the wrong time, selling at the wrong time but I learnt a lot from those mistakes. My investing strategy has evolved over time and I created this blog to share the lessons that I learnt. I believe by investing in individual stocks and following the right process, you can accelerate your journey to Financial Independence. Below, I share the reasons why it is a good idea to consider investing in both individual stocks and index funds.
- Pareto Principle: You are probably already familiar with this concept. As per the Pareto Principle, if you look at the performance of any index, you will notice that 80% of the returns come from 20% of the index holdings. Here is the breakup of the S&P 500 index for example and depending on the day you look, you will notice that the top 20% of the index holdings are responsible for most of the results. Therefore, the underperformers are a drag on the overall returns. Although these results are only for a short period of time, you will find that this is true over longer periods as well. The outperformance of index funds is due to a few top performers. I understand that it is very hard to pick the winners out of an index but this is where your expertise comes in. You can subscribe to a newsletter which will filter out some of the best companies (I subscribe to Motley Fool, there are many others) and due to your work, you will likely be familiar to some of those picks. You can start by investing in those companies little by little.
- Buying at the Top: Think about when most people start investing in the stock market. Usually, new money flows in the index funds after huge rallies and the index funds are forced to buy at the top. As an individual investor, you are likely dollar-cost averaging in your picks and you do not have this disadvantage.
- Selling at the Bottom: Similar to the last point, think about when most people take their money out of the stock market. Usually, people get scared during bear markets and sell their index fund holdings thereby forcing the fund managers to sell at the bottom. As an individual investor, you can be patient and in fact use this time to add to your favorite holdings when everything is on sale.
- Trim the Flowers and Water the Weeds: This point is a little complex to understand and it took me a while to grasp this. Think of an S&P 500 index fund like a pie chart, and the pie is broken up into slices based on market caps of its individual components. The fund managers are required to rebalance their portfolios every quarter according to market-caps of each company. You can imagine that the companies like Amazon, Apple, Visa etc. which have been growing over a decade will have a larger share of that pie every quarter simply because their prices have increased. On the other hand, companies like IBM, Exxon Mobil that have been falling over the last decade will have a smaller share of that pie simply because their prices have decreased. The fund manager of a typical S&P 500 index fund is required to rebalance those holdings every quarter, so they have to sell winners and buy losers to make sure that their holdings reflect the same weights that are carried in the index. One of my biggest investing lessons in buying individual stocks has been that winners tend to win for long periods of time. Therefore, you should dollar-cost average into a position on the way up. This is probably the worst strategy that you can think of in an index fund that they are forced to sell their winners to buy their losers. As an individual investor, you can avoid this disadvantage by buying more into your winners because you are not answerable to anyone but yourself.
- Window Dressing: The fund managers are compensated on the basis of Assets Under Management (AUM), basically the higher the better. So, sometimes their goal is to show better year-end returns to motivate new investors to invest with them. This can cause them to sell their winners early because they want to show a better performance at year-end. As an individual investor, you are only reporting to yourself and you are not driven by quarterly or end-of-year performance. Your goal is to invest for the long-term (probably decades) and you are not worried about a negative return over 12 months.
Once again I want to make this fact clear. It may sound like I am bashing the index funds and saying that you should not invest in index funds. Far from it. I am a strong proponent of investing in index funds. In fact, even after seeing this outperformance over the last nine years in my personal accounts, I continue to invest in index funds at every paycheck. I am only arguing that as individuals, you are likely witnessing some groundbreaking technologies in your line of work and those companies could provide you some investment ideas. Here are a few ideas of companies that I have used in my everyday life that could be great investment opportunities for the next decade : Twilio, Zoom, DocuSign, Etsy and Netflix. I am sure there could be many more but I believe these five would be great additions to any portfolios. I personally own all five of these and plan to hold them over long-term.
So, what do you think? Do you think that it is a good idea to invest a small portion of your savings in individual stocks? What are the top five public companies that you interact with that could produce exponential returns over the coming decade? Let me know by commenting below.