Index Funds vs Individual Stocks: Building the Core

Buy 20 shares of a broad-market index fund. That’s one order at one price. You now own a slice of every company in the fund’s index. Building the same spread by hand would take dozens or hundreds of separate purchases, each needing its own research and its own share of your cash.

That’s the case for funds as the base of a portfolio. The previous lesson showed how easily a handful of stocks ends up crowded into one sector, and a fund that tracks a broad index sidesteps that, since it covers every sector the index covers, in proportion, without you having to choose each name yourself.

Index funds and ETFs

Both hold a basket of securities chosen to match an index. The main difference is how you trade them. An exchange-traded fund, or ETF, trades like a stock during market hours. A traditional index mutual fund trades once a day. Its price is the net asset value, calculated after the close.

For a long-term holding, either works. Some accounts offer only one type, some charge a commission on one and not the other, and minimum purchase amounts differ, so check what your own broker offers before you settle on a fund.

What the expense ratio costs you

Every fund charges an annual fee. It’s called the expense ratio, a percentage of what you hold. You never see a bill. The fund takes it out of its assets. You just see a slightly lower return.

Seventy-two dollars sounds small. It isn’t, once you remember that the fee is charged every year on a balance you hope will grow, so the dollar gap widens as the account does, and the money lost to fees also stops compounding for you. In fee terms, 0.75% is 75 basis points. Find the expense ratio on the fund’s fact sheet or prospectus before you buy.

Core and satellite

One common way to combine the two approaches is a core-and-satellite portfolio. Most of the money goes into one or a few broad, low-cost funds, which form the core, and a smaller slice goes into individual stocks you’ve researched and want to own, the satellites around it.

Here is an example of the arithmetic, and only an example. On a hypothetical $20,000 portfolio, a split of 80% core and 20% satellites puts $16,000 into a broad fund and $4,000 into four stocks at $1,000 each. Suppose one stock goes to zero. You lose $1,000, or 5% of the portfolio. The core keeps doing its job either way.

The split that suits you depends on how much time you want to spend on research and how much you’re willing to see a single idea cost you. Some investors hold no satellites at all.

Watch for overlap

Two funds with different names can own many of the same companies. A fund covering the whole US market and a fund of large US companies are the standard case: the big companies that dominate one make up most of the other too. Holding both feels like more diversification. Mostly, it is the same bet twice.

Compare the two holdings lists before adding a second fund. Fund companies publish them on each fund’s page. If the top holdings match, the second fund may add little.

Research time is a cost too

Individual stocks ask more of you. Each one needs its filings read every quarter, its earnings calls followed, and a reason to keep holding it that you can state out loud, which is the work the How to Evaluate a Stock course teaches, and it adds up fast across ten or fifteen names. A broad fund needs an occasional look at its cost and holdings. That’s about all.

The dividend reinvestment calculator shows how reinvested distributions build a balance. Whatever mix you settle on won’t stay put, though. Prices move. The last lesson, on rebalancing a portfolio, covers bringing the mix back in line.