When it comes to saving for retirement, investors have several choices with regards as to how they decide to invest their capital. They can choose to put their retirement money into an index or mutual fund or pick individual stocks. Advocates of both types often of investment styles will tell you that their strategy is the best. I feel that each investor must decide for themselves which type of investments philosophy will work for them.

If an investor doesn’t have the time or inclination to research individual stocks, then placing one’s money into an index fund is likely a good idea.  Picking individual stocks takes time and patience.  Investors who find that the daily market fluctuations of individual stocks turn their stomach, an index fund, such as the S&P 500 ETF (SPY) or Vanguard 500 Index Fund (VFINX), will probably save them time and money.

If, however, the investor is willing to commit the time and patience needed to become a successful investor, picking individual stocks can lead to above-market gains. This article will explore several reasons why in the battle between index funds and individual stocks, I prefer investing in individual securities.  

Greater Investment Options

When it comes to index funds, your options are limited. Each broker usually offers their own S&P 500 index fund. Fidelity and others also offer their own funds on different sectors of the economy, like technology or industrials.  Many of these funds often overlap what they hold. While the funds might have different names, they can have very similar holdings. For example, if you buy a fund focused on technology it doesn’t matter if you buy through Fidelity or Vanguard, you are probably going to end up owning Microsoft (MSFT) and Facebook (FB).

By picking individual stocks you have nearly unlimited options. You can literally buy shares of a publicly traded company, even those in other countries.  Want to own a railroad, but prefer those that operate in Canada as opposed to the U.S.? Fill out a purchase order, hit the buy button and you’ll have shares of Canadian National (CNI) in your portfolio. Want to own a small or mid-cap stock in the energy sector? Instead of buying a fund that holds every stock in this sector, buy an individual company that you like. After researching healthcare names, if you think that Pfizer’s (PFE) pharmaceutical pipeline offers more potential for growth than Bristol-Myers (BMY), add PFE to your portfolio.

The point is, while your investment options with funds doesn’t offer all that much variety, you have a virtually limitless supply of stocks to choose from.  Being able to choose your investments means controlling what you own.

Knowing What You Own

Besides fees, which we will talk about below, my least favorite part of owning index funds or mutual funds is that you don’t always know what you own.  Index funds are required to own every stock in its index. The S&P 500 contains 500 companies so each index fund owns all 500 names. That means that for every company that you do want to own, say something like Apple (AAPL) or Johnson & Johnson (JNJ), you have to own other companies that you may not want in your portfolio. The chances of all 500 names in the S&P performing well is very low.

Managed mutual funds are the same way. Some funds are focused on certain areas of the economy. For example, the Aerospace & Defense Sector ETF (ITA) only buys stocks in this industry. In order to spread out their risk, the fund purchases many different companies within the Aerospace & Defense sector. If you think Boeing (BA) is overvalued and want no part of it at the current price, you’re out of luck if you choose to buy the ITA. When you hold shares of the sector fund, you get everything that they own.

When you are picking individual stocks, you can target companies you know and like and buy their shares. No one forces you to buy an individual stock the way that index and mutual funds do. If you think AT&T (T) has a brighter future than Verizon (VZ), you can simply buy Ma Bell instead of a telecommunications fund and be done with it. In a consumer staple fund, you’re likely owning both Coca-Cola (KO) and PepsiCo (PEP), though you may prefer one to the other.

Investors who are successful at picking individual stocks for their portfolio have to spend time researching their picks. In a portfolio of 20-30 names, the time required to understand stocks is very manageable. Owning index or mutual funds means owning hundreds of companies.  It is likely impossible that an investor has the time to understand every single company in their fund.

No Management Fees

Whether you decide to invest in index funds or individual stocks, you are going to pay a fee. That is just the nature of the business. Fees, depending on their size, can greatly reduce your return. Many investors don’t even know what their fees are. Fortunately, fees for both types of strategies are at their lowest ever, though investors still need to be aware of them.

Let’s use the Spider S&P 500 ETF to illustrate the costs of fees. This fund currently charges a 0.09% fee (index funds often offer low fees because they are not as actively managed as other mutual funds). Every year you hold this investment, you will pay 0.09% of the value of the account. Let’s say you have a $10,000 investment in SPY. You have an average return of 8% per year, which is about what investors should expect, and you hold the investment for 30 years. After this time, you would have a fund value of $97,944.81. That is a very sizeable gain and you paid $2,681.76 in fees over the life of the investment to achieve this amount.

Now let’s run the scenario for if you decide to invest in a fund with a higher management fee, say 1.5%. That same $10,000 investment becomes $63,943.97 after 30 years. At the end of three decades, you have paid $36,682.60 in management fees, almost 14 times what you paid in fees for owning the S&P 500 index fund. While you might think that a 1.5% fee isn’t all that much, this scenario shows that understanding what you are paying for fees is vitally important.

One big difference between funds and individual stocks is the fees.  It used to be that buying shares of stocks would cost hundreds of dollars. Now many brokerage houses, like Fidelity and Charles Schwab, charge as little as $4.95 per trade (when you buy or sell shares). You can buy as many shares of a company as you’d like and the cost will be the same. Let’s say you make a single stock purchase of $10,000 and the trade costs you $4.95. With 8% annual return for 30 years, you would have an investment of $100,621.62 when you subtract your trading cost. That $4.95 trading fee represented just 0.0049% of your total investment. And that fee was a one-time only issue.

While returns from index funds will track their benchmark, individual stocks can grow at above market rates for long periods of time. If that $10,000 investment in a stock grows at 9% per year, just 1% above our initial scenario, the value of the position balloons to $132,676.78. And you still only pay the cost of the first trade.

Of course, most investors don’t have $10,000 to invest at one time. Even making ten $1,000 purchases of a stock at $4.95 a trade is half (0.005%) of the fee that the SPY charges. And you only have to pay the trading fee at the time of purchase, not every year as you do with index funds.

Final Thoughts

Investing in index or mutual funds is likely appropriate for those who don’t have the time or patience to research individual stocks. If you fall in this camp, the best outcome for you is to put all of your money into an S&P 500 index fund. Those who do want to be in charge of their own retirement, however, can likely be successful in their endeavors.  Individual stock picking offers an immense variety of companies to choose from, whereas index and mutual funds options are somewhat limited. Owning a basket of individual stocks also allows investors to know their companies very well. Well, informed decision making can lead to greater results. The most important difference between individual stocks and funds is the level of fees. Individual stocks only have fees at the time of buying or selling, regardless of the size of position. Funds, on the other hand, take a piece of the total portfolio every year. Why give up more of your retirement nest egg when you could keep it all for yourself?