This is a five part series written by Trent of Stock Market Beat and each part will be published this week. In Parts 1 through 4 we showed how an investor can determine the value of a stock. All of the same guidelines can be used to value a stock index. For many investors, especially those just starting out, indexes offer many advantages:
- When you buy an index fund you just pay one commission rather than one for each stock you buy.
- An index fund gives you diversification into many stocks. If any one stock goes bankrupt or is manipulating earnings, it will get smoothed out by the better ones.
- When you buy a stock you should know it very well: its business, its competitors, its financial metrics, and so on. If you buy an index, all of these things get smoothed out.
On the other hand, if you do know a particular stock very well, there is a good chance you will know the best time to buy and sell it, which would allow you to earn a better return than just the “average” of the index. We showed in Part 2 how a small difference in annual return can add up to big differences in the investor’s wealth at retirement. Plus, it can be fun, in a nerdy sort of way. If you have ever gone to a horse racing track you probably saw a bunch of guys sitting around reading the racing form, trying to figure out which horses had the best chance of winning. Picking stocks is similar. It is a very competitive field, and it takes lots of practice to get good at it, but when you do you get the dual rewards of having fun and “winning” – making your investments worth more than they would be in an index fund.
If this doesn’t sound like fun to you, stick with an index fund. If it does, start learning. There are plenty of good books out there, or you may want to try Financial Education, Stock Market Beat (the author’s site), or one of the other online sources for beginning investors.
William Trent, CFA has been a securities analyst since 1996. Since March
2006 he has been the editor of
Prior to that he was Senior Equity Analyst for New Amsterdam Partners LLC,
which manages $6 billion for pension funds, endowments and other
institutions. His experience covers all market-cap sizes and is primarily
within the TMT (Telecom, Media and Technology) and Transportation sectors.