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Single stocks or index funds?

Investing in the stock market can be daunting so actively managed mutual funds has traditionally been the go-to vehicle for the average Joe who wants an easy peasy investing solution. Index funds (passive funds and ETFs) have however become very popular in the recent years due to their lower costs (read more about the impact of fees here) and their simplicity and transparency. Some people however still think the costs are too high and some nationalities are restricted due to unavailability of funds or unfavourable taxation. A way around these issues is to buy the stocks yourself and invest like an index fund.

Buying stocks myself? Sounds fancy, but I don’t have the time and skills for that.. Do I?

Invest in individual stocks like an index (for diversification and simplicity)
Investing in individual stocks can lead to a bad experience if you only invest in a few and trade a lot. One solution is however to invest like an index fund; diversify (invest in many different stocks) and have a buy and hold approach. This is much like what an index fund do. It spreads investments across a whole index (diversification) and doesn’t spend a single second wondering if X or Y or Z is suddenly under- or overvalued (buy and hold).

So the “invest like an index fund” strategy is basically just buying as many different stocks as you can within an index without buying too small positions that makes trading costs significant. When doing this your portfolio enjoys the diversification of an index and you can enjoy the simplicity of just buying a random new stock every time you want to add to your portfolio. Just don’t buy too much from the same sector or same country. (scared by us saying Random stock? Read our post about efficient markets here)

The advantage of Do it yourself compared to index funds
There are advantages to this strategy compared to investing in index funds.

  • Taxes (we don’t know if this is the same in YOUR country) – With this strategy you can optimise your tax payments by deferring them as long as possible and thus squeeze that last returns out of it before it is payable. As your portfolio over time will contain both stocks that you have lost money on and gained money on, you can net out returns if you aren’t selling your whole portfolio at the same time. As you (in Denmark) only have to pay taxes in years with positive realised returns, netting out winners and losers will result in no taxes until you have no more stocks that you lost money on.
  • Costs – Even though index funds are typically inexpensive they are not free and they will take a small cut every year. If you follow the “invest like an index fund” strategy you will only face trading costs in the beginning and in the end when you trade. If you invest at low trading fees and holds the portfolio for a long enough time this strategy could save you some money.
  • Investment style control – A broad index might contain stocks that does not match your investment style/needs. With the “invest like an index fund” strategy you can leave out these companies and stick to the rest. This might be relevant if you do not want to invest in regulated utilities that is known to offer a low but stable return. This advantage is however a “maybe advantage” as you might leave out a performing sector.
  • Personal control – Some people have ethical issues with investing in a whole index as it potentially contains companies that pollute, utilise child labour or operates within warfare. The “invest like an index fund” strategy gives you the control to pick or leave out companies that you feel strongly about.

The disadvantage of Do it yourself compared to index funds
There are however of course disadvantages as well.

  • Trading costs – As the “Invest like an index fund” strategy requires you to buy many different stocks you are making a lot of trades in the process of setting up the portfolio. If you like us use a broker who charges a fixed minimum fee per trade, you have to buy in large enough quantities to keep the fees insignificant in the larger picture. Keep in mind that this strategy as a rule of thumb requires at least 20 different stocks in your portfolio. And we will argue that 20 only works if you plan to add more in time.
  • Your own ego – The worst enemy you will face utilising this strategy is yourself. Through time you will probably begin to think that this and that stock is under- or overvalued. If you do this you might be tempted to trade irrationally and thus add on unnecessary trading fees just to see the stock you just sold double in value.

With this strategy you might not end exactly like an index as it rebalances every now and then, but that is okay. There are many many indexes out there so who says that the one you are looking at will be the best of them? The invest like an index strategy just follows the thoughts behind index funds. It is up to you if you want to following a narrow index, a wide index or if you want to buy around the globe.

2 thoughts on “Single stocks or index funds?

  1. Hi TAF,

    Great post! I enjoyed reading your take on a DIY index investment method 🙂

    I agree to some extent that you can achieve diversification through your method that is more than enough – at least that is what I learned in my finance classes. However, you will still have to buy quite a few stocks in different parts of the world in different sectors to get a “good enough” diversification to not be prone to individual stocks/regions/sectors fluctuations (if you want to be globally diversified across regions that is). I believe the transaction costs of keeping this sort of balanced to represent the market can become quite high – and it is practically impossible to keep it as balanced as an index if you only invest once a month.

    Also, I guess taxes are the same for Danish index funds (not ETFs) compared to owning individual stocks, or am I wrong here?

    But your best argument is of course that there’s a lot of money to save (and a big upside over a long life), if you can cut out the funds’ management fees that are relatively high in Denmark.

    Are you pursuing this strategy actively yourself, or is it mostly theoretical for now?

    All the best,
    Carl

    P.S. I really like your WP theme – I’ve been looking for something similar for a while now.

    1. Thanks for the kind words on the post and the blog. Much appreciated!

      We are somewhat pursuing this strategy, as we believe costs and ETF taxes makes it is the best alternative in the long run in Denmark. We are very interested in stocks, so it is a hobby for us to pick out the stocks we buy. As long as we don’t concentrate our picks in the same geography and industry it doesn’t really matter if we pick them based on beliefs of upside potential or buy randomly according to this strategy 🙂

      Regarding balancing and diversification – We are in a build-up phase for our portfolio so our strategy is to buy in areas we are missing or have a low exposure to. This means that we are not balancing in the sense of selling if one part of the portfolio goes up. Instead we add more to the lacking parts. The transaction costs we take are thus only the costs of adding to the portfolio once a month. I guess that is the same for anyone else except if you use services like Nordnets monthly savings system?

      In regards of taxes you are correct. Taxation is the same on those funds and individual stocks in Denmark – you are taxed when you realise your gain. The difference between them is that you have your tax bill split up with individual stocks so that you can sell winners and lossers at the same time and thus net out taxes and deffering the tax bill to the last part of the portfolio.
      An example is if you own 10 stocks with fairly spread out returns (positive and negative). If you then need some money now for a repair on the house and the rest of the money in 5 years for another expensive thing, you can sell the stock you lost 90% on and the stock you won 90% on at the same time and thus pay no tax on the money for the repair now but then pay more tax 5 years later when you sell the rest of the portfolio. The tax is the same but you are deferring it and thus get interest on the tax for 5 years more. Does that answer your question?

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