To index or not to index? (And why that's not really the question, Fool.)
 | Emily Flippen Motley Fool analyst |
'When you play a single stock, you're nothing better than a blindfolded monkey.'
That's my favorite (100% misguided) quote from personal finance guru Dave Ramsey. When he said that, he was predicting the imminent demise of average Joe investors, who he said are too consumed with finding the next big stock or the latest blockbuster trend. To be fair, he did say that portfolio-level 'experts' might beat the market — but that 'you and your golf buddies' simply have a 'bad hobby.'
Ramsey's philosophy helps explain the popularity of indexing, or investing your money in low-cost index funds that mirror the market. Advocates of indexing don't think stock-picking is a skill that can be cultivated and studied; instead, they think it's a game of luck where the chance of success is equal to that of a blindfolded monkey taking shots at a dartboard.
But do you really have to choose between the two investing strategies? Or is there another way to profit?
You can't beat the market alone (or so they say)
Loyal indexers call on a mountain of studies that show that, on average, individual investors lose to the market. And it's true that the cards are stacked against the average Jane. As a practicality, most people don't have time to really study and understand the companies they're investing in. And from a behavioral finance standpoint, it's really hard to not sell when the markets are dropping and to avoid the fear of buying at the top. So for a lot of investors, indexing is a solid option that shouldn't be ignored.
But there's more to the story. Not every individual investor (as we Fools well know!) tries to time the market, day-trade, or play in penny stocks, yet these are the investors those studies seem to highlight. What's more, the studies cited by indexing champions are often dated. New technologies, regulations, and even industries have transformed the investing landscape for individual investors. Low-cost or free online brokerages are just one example. Maybe there's room for individual investors after all ...
Beating the market with 'index plus a few'
In fact, passive and active investing don't have to be mutually exclusive. Although your personal portfolio allocation comes down to many factors, including your age, risk tolerance, and expectations of returns, I think you can build a market-beating portfolio by investing in a handful of outstanding buy-and-hold stocks and a diversified base of indexes.
This strategy, which I like to call 'index plus a few,' is a way to incorporate stock investing into part of your larger portfolio. It ensures that you're not acting like a blindfolded monkey — and it gives you time to still have a life outside investing.
How to do it
To make 'index plus a few' work for you, invest the largest portion of your portfolio in a broad range of index funds and a smaller percentage in long-term, individual stock holdings. Your goal, of course, is to capture the returns of the index ... plus a few extra percentage points.
How do you decide how much to put in the indexes versus the stocks? As with all things investing, your mileage will vary based on your situation. If your investing dollars are already stretched to the limit or you're less confident in your stock-picking skills, start with a tiny percentage in stocks. As you gain investing knowledge or your circumstances change, so can the proportion of money you devote to indexes versus stocks.
The key is to get started with amounts you're comfortable with — and know that not everything is riding on the decision of the moment. Simply dip your toes into stock-picking. You won't drown with an 'index plus a few' and, who knows, you might become a good swimmer (and maybe win a few races)!
Owning individual stocks makes you smarter
And therein lies the point, Fool! By investing in a few individual stocks, you're not just mindlessly dumping money into one index fund and giving up hope of consistently beating the market. Instead, you're slowly gaining knowledge — with The Motley Fool's help — and learning about investing concepts such as expense ratios and dividends. Even if it's only for a few minutes each day, actively managing a small bit of your portfolio by owning individual stocks will expose you to the whole broad world of investing. If nothing else, you will have new insight into the index funds that remain at the core of your portfolio. You will see the entire financial world in a new light.
Need an extra boost of confidence to buy some stocks? If you have a passion for people, history, fashion, or technology, you are a born investor. You are capable of taking the first step toward buying a stock that taps into your passions ... and that means you are capable of beating the market! We're here to help, so keep reading our Foolish stock recommendations and see which ones strike your fancy. Combine them with a few index funds, and if you've made smart stock choices, you too will start profiting from 'index plus a few.'
| Emily Flippen Motley Fool analyst |
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