Index Funds vs Stocks: Pros, Cons and Differences

Both index funds and stocks provide unique investment opportunities with multiple advantages and potential drawbacks. This makes it crucial for investors to understand their differences before making a decision. Index funds, which track the performance of a specific market index, provide a diversified portfolio with typically lower fees and reduced risk. This makes them an attractive option for those seeking a more hands-off investment approach. On the other hand, investing in individual stocks allows for greater control and the potential for higher returns. But it also comes with increased risk and the need for more active management. Knowing the difference between index funds vs. stocks can help you decide which is the right investment choice for your portfolio.

Consider working with a financial advisor to find the best mix of individual shares and index fund holdings for your portfolio.

What Is an Index Fund?

An index fund is a portfolio of assets held and managed by an investment firm. Generally, it is made mostly or entirely out of stocks and corporate bonds.

Like stocks, you invest in an index fund by purchasing individual shares, giving you a percentage of the overall portfolio equivalent to how many shares you bought. You are then entitled to the fund’s returns on that pro-rata basis.

For example, say the ABC Fund releases 50% of its value in the form of 100 shares. This means that the firm that manages the fund has retained ownership of half of the portfolio. The other half has been offered to investors. If you buy one share of this fund, you own 0.5% of the overall portfolio and are entitled to 0.5% of its returns.

This is the basic structure of what is called a fund-based asset, which firms typically sell as mutual funds and ETFs. An index fund is a specialized form of fund-based asset. With an index fund, the managing firm selects the portfolio’s assets to match the index that tracks a specific segment of the market – typically, a specific idea, industry, sector or other market metric.

How an Index Fund Works

The goal of the fund is to match the index’s performance. This is different from many fund-based assets, which are built to simply generate returns or mitigate risk, regardless of the market as a whole.

Indeed, unlike other types of assets, an index fund that loses value often works exactly as designed. For example, a firm might build an index fund around the technology sector. This means that the fund tracks the performance of technology stocks as an industry. If tech companies perform well and gain value, the index fund will gain value, too. If tech companies hit a rough patch and their prices fall, the index fund’s value will decline in response.

To do this, the firm running an index fund will build its portfolio out of assets relevant to the performance of its chosen metric. For example, a firm that builds a technology sector index fund might build a portfolio from technology company stocks, bonds issued by technology companies and any other assets that reflect the performance of the tech sector as a whole. Depending on the fund, this firm might purchase options contracts in gold, silicon and other semiconductors. Or it might invest in logistics companies known to work heavily with technology companies.

The exact composition of an index fund is up to the firm managing the fund. Investment firms work very hard to create the right formulas for an index fund that succeeds in tracking its industry’s value.

However, the overall principle is consistent. An index fund is comprised of assets that the firm believes represent the value of a market segment.

The most popular index funds track major market sectors, including:

Market indexes, such as the S&P 500 and Dow Jones Industrial Average, where an index fund will track the value of these market metrics.
Industry indexes, where a firm builds its index fund to track the value of an industry as a whole, such as retail, technology or energy.

How Stocks Work

A stock, meanwhile, is an ownership stake in an individual company. When you purchase stock, you acquire fractional ownership in the underlying business. For example, say a company releases its entire value for sale in 100 shares of stock. If you buy one share of that company’s stock, you now own 1% of the company itself.

Depending on how that business manages its stock, this might entitle you to a share of its profits, which are distributed in the form of dividends. It can also entitle you to a voice in governing the business based on how many shares of stock you own. (However, major firms can release billions of shares. So it takes a significant investment before you receive a meaningful voice in the affairs of a publicly traded corporation.)

Mostly, you profit off of a stock through what is called capital gains. When the company does well, other investors take an interest in it. This increases demand for the company’s stock, which, in turn, drives up its market price. If that price goes up while you hold the stock, you can sell your shares for more than you paid to buy them, making a profit.

Stocks can also pay returns in the form of dividends when the company pays its shareholders a portion of the corporate profits.

Index Funds vs. Stocks

The biggest difference between investing in index funds vs. stocks is risk.

Individual stocks tend to be far more volatile than fund-based products, including index funds. This can mean a bigger chance for upside, but it also means a considerably greater risk of loss.

By contrast, the diversified nature of an index fund generally means that its performance has far fewer peaks and valleys. Like all fund-based products, an index fund holds several different assets in its overall portfolio. Instead of investing in just one stock, as you do with a stock, you are investing in dozens, if not hundreds, of stocks, bonds and other assets.

This means that even if one company loses value, there’s usually another company to make up for that performance. Of course, if one company posts huge gains, those returns will be watered down by the rest of the portfolio as a whole.

The diversification of an index fund depends on the nature of the fund itself. A fund that invests in a specific industry or market sector will be less diverse than a fund that invests in the market as a whole.

For example, you might invest in a technology sector index fund and an S&P 500 index fund. It is easier for something to happen to the technology sector specifically than the entire stock market. An industry can dip or boom more easily than the whole market can slide into recession or surge.

Index Fund Advantages

For an individual investor, index funds generally have two major advantages over investing in an individual stock.

First, very few investors ever beat the market. Studies consistently find that more than 90% of professional investors cannot pick stocks that outperform the market as a whole in the long run.

Take two investment portfolios. Put nothing but an S&P 500 index fund in one of them, then actively buy and sell stocks in the other. Your index fund will be worth more year-over-year almost every time. While this isn’t an ironclad rule, you will make more money with index funds nine times out of ten.

Second, an index fund simplifies the investment process. Investing in the stock market means tracking performance, following company fundamentals, reading earning statements and much, much more. This is difficult to do well and can quickly eat up your time and attention.

Investing in an index fund is a passive investment strategy. You buy the asset and then leave it alone to collect value and generate returns. There’s no need to follow performance or play the stock market.

Investing in stocks is not unwise, and many investors enjoy active investing. They find it a thrill to try and beat the market. However, like all speculative assets, you should make sure that individual stocks only make up the speculative part of your portfolio. Invest money in these assets that you can afford to lose. For the long-term, stable segment of your portfolio, index funds are often preferable.

How to Use Stocks and Index Funds Together

Using stocks and index funds together means combining the strengths of both strategies in one portfolio. Index funds provide instant diversification by holding shares of many companies, helping to reduce overall risk. Stocks, on the other hand, let you invest directly in companies you believe will perform well and give you a chance for higher returns.

You can use index funds as the core of your portfolio to track the broader market while using a smaller portion to invest in individual stocks. For example, you might allocate 80% of their money to index funds and 20% to hand-picked stocks. This allows you to benefit from long-term market growth while still having the opportunity to capitalize on specific stock opportunities.

This strategy also makes it easier to manage risk. Even if one of your chosen stocks performs poorly, the index fund portion helps keep your overall portfolio stable. As your investment goals or market conditions change, you can adjust the mix of index funds and stocks to match your preferred level of risk and return.

Bottom Line

A stock gives you one share of ownership in a single company. An index fund is a portfolio of assets that generally includes shares in many companies, as well as bonds and other assets. This portfolio is designed to track entire sections of the market, rising and falling as those segments do. Knowing when to invest in index funds vs. stocks can help you build a diversified portfolio that is set up for long-term growth.

Work with a financial advisor to find the right balance of investments for your portfolio.

Tips on Investing

Should you take more risks? Is it time to start playing it safe? We can’t tell you that here, but it’s exactly the kind of conversation you can have with a smart financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool matches you with up to three vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Deciding between stocks and index funds isn’t the only choice careful investors face. Among other challenges is getting a good estimate of how your portfolio will do over time. That’s where a free investmenet calculator can come in handy.