Why Index Funds Are Not The Only Way To Go

I’ve been an advocate of index funds for the past, well ever.  I bought into my first index fund while I was a college student at 18. I strongly believe that for the average 401K investor stock index funds are an excellent tool to build wealth. And I will continue to invest in stock index funds.

The Advantage of Stock Index Funds:

Index funds are a collection of several hundred to thousands of different companies.  This allows for easy diversification and greatly reduces risk.  If 1 company in the index goes completely under, you probably won’t even notice it.

Index funds are also easy: They take responsibility away from the individual.  As an individual if you invest in an index fund you aren’t responsible for learning about different companies, their strategies, and making educated decisions o how they will fare over the long term.  You just say “Well I’ll buy everything and a rising tide will lift all ships.

This is great for the average person who wouldn’t even have a 401K account if not for automatic enrollment.  The majority of people in this country flat out are not motivated enough to learn about retirement accounts to begin with, so expecting them to also learn to appraise stocks is not realistic.  Index funds solve this problem.

For those who are able and willing to learn to appraise companies and to understand the different risk profiles of index funds and individual stocks, there is the potential to earn much greater returns than with index investing.

The Problems With Index Funds:

Index funds are mediocre.  Buying index funds is like being in a class at school.  The teacher says if you leave class right now you will be given a C for credit, but if you stay and take the test you could earn an A.  The difference is that a C, the average grade is actually not that great and someone who puts forth effort will likely do better than a C.

Index funds also own terrible losers: In 2019 I owned Sears stock.  Not because I bought it individually, but because it was in the index funds I owned.  Index funds have to own losers to, even if its OBVIOUS that they are losers!

Index funds don’t always include high growth companies.  For example, Tesla which has been a standout stock since its IPO 10 years ago has not been included in any index funds.  With Q2 of 2020 Tesla has now hit 4 consecutive profitable quarters and can be added to the index, but the S+P 500 declined to add Tesla.

Index funds still have a lot of volatility:  They aren’t a perfectly safe vehicle.  In both the 2009 and 2020 recessions….

The Opportunity of Individual Stocks:

With index funds people are shooting for a 7% – 10% annualized return.  Over an investing span of 4 decades the effect of only a few percentage points make a massive difference in total net worth growth.

  • $1,000 invested over 40 years at 7% grows to $16,000
  • $1,000 invested over 40 years at 10% grows to $53,000.
  • $1,000 invested over 40 years at 20% grows to $2.8 Million.
  • $1,000 invested over 40 years at 30% grows to $140 million.

It would be irresponsible of me to not write about opportunities much greater than index funds. If you have significant savings these out sized returns are well worth searching for and taking on additional risk.  If it takes 200 hours of research to find 1 stock that has a high likelihood of returning 20% over 7%, and you have $10,000 to invest in it, then that 200 hours was well worth it.

  • With $5,000, investing all $5,000 into index funds at 7% should grow to $80,000 after 40 years
  • If you invest $1,000 into 5 individual stocks and 4 of them go to $0 but 1 gets 20% returns for 40 years total will be $2.8 Million.

Over the years I have bought 4 individual stocks that I wish I had bought earlier, bought more, or not sold. I used to think that picking a good stock was just a “spin on the roulette wheel” and that I was more likely to lose all my money than to beat the index of every single stock.

The first stock I ever bought was 100 shares of Redhat Linux stock for $6 a share in 2002. I was 16 and my dad suggested that I invest in the company.  I sold for a small profit when I was 20 and used that money as part of my down payment for a first time home purchase.  In 2019 IBM purchased Redhat for $190 a share.  That $600 would have grown to $19,000, a 22.5% annualized rate of return over 17 years.

The second stock I ever bought was Hansen Natural.  You could say I got lucky on this one. I didn’t do much research and “jumped on the bandwagon” of a stock that was moving up quickly.  I invested $1,000 in 2005 at around $1.25 a share (adjusting for splits).  Hansen Natural changed its name to Monster in favor of its breakaway energy drink.  Today the stock traders for around $79 a share.  That $1,000 would be worth over $61,000 today, a 31.1% annualized rate of return over 15 years. At the same time I bought $1,000 of SpaceDev, which didn’t go anywhere and ended up being a break even deal.

The third stock I bought was Tesla is 2016.  I have held on to my shares and will not sell.  I invested $12,000 at $200 a share ($40 split adjusted).  I recently invested another $4,000.  Today Tesla is trading at $450 a share (2,250 split adjusted), over 10X my original investment, making that 12,000 now worth $130,000 an 87% annualized return over 4 years.

The fourth stock I bought was in March of this year.  I used my spare investment cash, which was only a couple grand, to invest in Whirlpool stock. The PE ratio had dropped to 4, and Whirlpool tends to have very sharp declines and very sharp recoveries. I bought at $74 a share and sold less than 3 months later at $130 a share, an annualized return of 852% over 3 months. While I don’t think Whirlpool is a long term growth stock, I did my research and found a way to quickly increase my spare cash.

In December of 2017 I wrote an article on how I “missed out” on Amazon.  I basically assumed that with it nearing a $1 trillion market cap its high growth days were behind it.  Amazon was at $1,160 then, today Amazon is trading at $3,144, across 2.5 years is a 47% return. 

Individual stocks that are winners are not exceptionally rare. Since I have owned 3 stocks that have way outperformed the market over a long period of time, I think that the general mindset of investors against individual stocks is too great.

And if you invest in 2 individual stocks per year, after a few years you should be well diversified anyways.  I’m not talking about putting all our wealth in 1 individual stock.

My Solution:

Invest 10% of your income into retirement accounts in index funds: I still think index funds should be a conservative base for a retirement portfolio, that even if everything else goes bad, coupled with Social Security, you should be able to retire with dignity on just investing 10% of your income in index funds and forgetting about it. I don’t recommend investing in index funds beyond 10%.

For someone who earns throughout their career the median US income of $60,000 a year 10% would be $500 a month.  Over 40 years at 8% returns this would grow to $1.75 million. Add in a 5% employer match and it would be $2.6 million.

Even someone earning half the median income at $30,000 a year would still grow to $872,000 without an employer match and $1.3 million with an employer match.

In the lowest situation of $30,000 annual earnings with no matching funds having $872,000 would generate $43,000 in annual income ($3,633 monthly) using a 5% withdrawal rate.  Add in the median Social Security retirement benefit of $1,422 and you’re hitting $5,000 a month in income!

Invest 10% of your income into individual stocks: If you are saving beyond 10% the added wealth you can build is icing on the cake, so its OK to be more risky with this money.  Since I advocate for saving a minimum of 25% of your income, then you have 10% left to invest in individual stocks. Invest 10% of your income into individual stocks inside your retirement plans (IRAs). Do your research and make educated decisions based on 10 to 50 years, not next month or next quarter.

Invest The Rest Into Real Estate:

Past the 20% you are saving in retirement accounts, invest the rest into real estate.  First pay off your house.  This is another balance towards conservative investing.  Paying off your home given todays interest rates is guaranteeing you a 3.5% return.  I believe that having a paid off home is a high psychological benefit, and can also benefit you if you choose to invest in rental real estate.

Then look into using the BRRRR method to gain rental houses.  This is further diversification that is well protected from inflation, is a necessity, and has very preferential tax treatment. Using leverage allows you to have no cash stuck in the house but still have a substantial positive cash flow from it. Check out the book Buy, Rehab, Rent, Refinance, Repeat: The BRRRR Rental Property Investment Strategy Made Simple for more information on the BRRRR method.

Invest $10 a Week Into an Investment Account For Each Child:

The best time to give away assets is before they appreciate. If you are doing all of these steps you will become a multi-millionaire.  Giving away small sums of money earlier in life to your children gets them interested in investing, transfers assets before they appreciate, and sows the seeds for building generational wealth.  I use stockpile with my kids.  We have 2 accounts for them.  In one account that is set up under me as the custodian we invest a portion of their earnings from chores.  In the other account under my wife as a custodian we invest $10 per week for each of them.  (We actually do $43 a month, but the math works out the same, this just saves 3/4 of the investing costs since it costs $1 per trade).

We are just now starting this.  Since my kids are older the effects won’t be nearly as great, but we should see these results for our grandkids.  

$10 a week at 8% growth from birth to 18 will grow to $20,643 at 18 and $875,000 at 65.

$10 a week at 15% growth from birth to 18 will grow to $46,897 at 18 and $44,586,000 at 65.

I Don’t Believe in Using 529 Plans.  Here’s Why:

  • 529 plans are an asset of the adult, not the child.  The wealth is not transferred.
  • 529 plans can only be spent on college expenses, or else you face penalties and taxes
  • 529 plans can be transferred to another sibling or family member, once again, they are not the proper vehicle for building long term wealth.
  • UGMA accounts are instantly the asset of the child
  • UGMA accounts as long as no stock is sold will not have capital gains costs
  • Assets in a UGMA can be strategically sold to only sell long term capital gains at a 0% tax bracket to help fully fund retirement accounts early in their careers.  Essentially transferring the assets built up in the UGMA to Roth IRAs and Roth 401Ks.

What do you think about investing in individual stocks?  Do you like my idea of focusing on index funds first then going into individual stocks and real estate? What percentage of your investing dollars goes to individual stocks?

John C. started Action Economics in 2013 as a way to gain more knowledge on personal financial planning and to share that knowledge with others. Action Economics focuses on paying off the house, reducing taxes, and building wealth. John is the author of the book For My Children's Children: A Practical Guide For Building Generational Wealth.

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