Index funds try to achieve the same price increases as an index such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index or the Wilshire 5000 Total Market Index. These funds buy the same stocks as one of the indexes do. If you want to do better than the index, you can buy and sell individual stocks.
Index Mutual Fund Advantages
Index funds have low management fees. Managers don't have to spend time searching for stocks to buy, because they simply mirror what a particular index holds. When the index changes stocks, so does the index fund. You can expect about the same performance you would get from holding all stocks in the index. Since buying that many stocks would require a lot of money, an index fund offers the advantage of allowing you to invest a small sum, such as $500 or $1,000. The fund pools your money with other investors to buy all the funds in the index. You get the benefit of that diversity without the cost.
Index Mutual Fund Disadvantages
Index funds give you average returns. Whatever the index does, your portfolio does. Because you pay management fees, you can actually do worse than the index, because part of your profits goes to pay fund managers. If the index drops in price, your investment value drops with it. Index funds do not protect you from a market crash or even from steep market corrections, because they hang onto the same stocks as the index holds.
When you buy individual stocks, you can keep your costs lower than you would pay to a manager of an index fund. You can do this by finding the least expensive online broker possible, with some offering access to the market for as low as $4 per trade. If you discipline yourself to hold onto your stocks and not trade often, this cost can be lower than with an index fund.
Focusing on high-quality stocks will help you match or beat an index. These are stocks that have shown consistent growth, have a history of raising dividend payments and have high profit margins, according to the Seeking Alpha website. The combination of low expenses and reasonable price appreciation can help you beat the returns you would get from an index fund.
You can be wrong about your stock picks. No matter how much research you do and how sure you feel about an individual stock, something can go wrong. A manager can get caught up in a scandal, or a company's competitor can outperform your company. You don't have the protection of diversity that you get in an index fund. In a diverse group of stocks, when one fails, the others may hold up. With all your money in a few stocks, you are much more vulnerable to losses.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.