Photo by Austin Distel on Unsplash

One of the hardest things to understand when you first starting investing is to know whether you should buy individual stocks or invest in index funds. This was a problem I encountered when I first started investing.

The idea of investing in Apple, Facebook and Tesla was appealing to me, yet I didn’t know whether I should put that money into an index fund instead. As a newbie investor, this can be a confusing problem.

The problem I had was that I was keen to get started with investing, but I had little knowledge of the stock market or best practices regarding investing. I could have easily put a lot of money into a variety of stocks, but it might not have been the best idea.

This is what puts a lot of people off investing, and what stopped me investing for so long. I felt like there was a barrier to entry. Unless I immersed myself in the market, there was no other way to understand what to do.

Instinctively, I knew that my money would be safe in an index fund, but I also knew I’d struggle to resist the lure to invest in companies that I admired and thought would grow over the years.

When you invest in an individual stock, you’re taking a gamble that the company will continue to grow and the share price will go up in the future. While you’re doing the same thing with an index fund, the risk is much lower.

That’s because the fund consists of hundreds of companies instead of just one. If one company goes bust, which can happen (Enron), they are replaced by another company. This exposes you to much less risk than if you had all your money in one stock.

While it’s wiser to invest in an index fund from a risk perspective, it’s not always the right idea. Knowing what to do when you’re a newbie investor can be tricky, but once you understand the basics, it’s easier than you think.

Index funds are safer

There’s no question that investing in index funds is safer than investing in individual stocks. You only have to look at previous recessions and crashes to see that the stock market is volatile.

Companies come and go, and if you put too much money in one of them and they go bust, your money is gone with it. This happened with Enron, Lehman Brothers and many other companies too.

With an index fund, this risk is minimised. Perhaps the best-known index is the S&P 500. It’s highly unlikely that every company on that index will become bankrupt if there’s a recession or crash. One or two might go out of business, but there’s more chance of the moon turning blue than all of them going bust.

What you’re doing when investing in an index fund is buying a diversified selection of stocks in an easy investment. Some index funds provide you with exposure to thousands of companies all rolled into one. This lowers your risk significantly as your risk is spread over a broad area.

Then, there’s also the fact that many index funds have beaten other types of funds in terms of total return. As the funds aren’t actively managed as much as actively traded funds, they have lower interaction costs which bump your return in the long run.

To put it simply, index funds are safer and almost guaranteed to provide you with returns over the long run.

But individual stocks offer greater returns

While index funds are safer and offer consistent returns over the long-term, they’re never going to be able to match the returns that you can see in a short space of time with certain stocks.

In recent years, Tesla is a case in point. In the past year, the stock’s price has increased by 400%! This is an insane figure. In my case, my own shares of Tesla have gone up by 270% since I first invested in the company back in July 2019.

Not every stock is going to do this, which is why it’s often better to invest in an index fund if you’re starting out. If you want to invest in companies such as Apple or Microsoft, you need to do your research.

Check the companies bottom line, have a look at how much debt they have, whether they are exceeding or falling short of market expectations. Yahoo Finance is a great place to peer into the numbers behind a company and determine whether they are worth investing in.

It’s a common refrain that you’re capital is at risk when you invest and it’s true. Investments that you think will do well can easily fall short. The market is unpredictable, which is why it’s easy to lose a lot of money.

However, if you're savvy, do your research and make informed investments, you can make a lot of money from investing in the right stocks. Index funds are great, but they’ll never offer a 400% return in a year.

The best approach is to do both

Both approaches have their merits and their downsides. If you invest the majority of your money in individual stocks, you’re exposing yourself to a lot of risk. While it can be argued that you’re not taking enough risk if you only invest in index funds.

In truth, the best option is to do both, but with caveats. My advice would be to follow something similar to what

Nassim Taleb calls this the barbell strategy. You want the bulk of your investments to be in safe assets, such as government bonds, commodities and index funds. Then you’re free to invest the rest of your money on more speculative assets.

By doing this you get the best of both worlds. You’ll be able to build up a solid position with your index funds, that will benefit you in the long run. Then you can take a punt on a few stocks that you feel will do well. If they come good you’re up, if they don’t you can cover the losses through your safe investments.

Going all-in on individual stocks is risky if you don’t know what you’re doing, while you’re missing out on potential gains if you don’t research individual stocks to invest in.

By adopting a dual strategy you keep your investments safe while giving yourself the wiggle room to take punts that could pay off.

If you’re looking to get into investing, the best strategy might be this. Put the majority of your money in safe investments, say 90%. Then, be speculative with the rest.

It’s a long-term view, but one that will bring you rewards if you stick with it.

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