Index funds versus individual stock picking

“Where should I invest my hard-earned money?”

This question invariably puts investors into a serious dilemma as to which investment option should they consider. They get deeply consumed in the process of assessing, determining and considering options which would render optimal returns to them, involving minimal risk and offering safety to their capital.
Investment in equities (individual stock picking) and various types of mutual funds are two very obvious investment vehicles that would come to investors` mind. Equity funds, debt funds, balanced funds, index funds and so on are the several types of mutual funds, which can be considered. Which type of fund is better amongst them? The answer to this question would depend upon the investment goal, risk appetite and time horizon of the investor.
Let us compare individual stock picking and index funds in detail:
Individual stock picking is nothing but merely equity investing. It is the most popular investment vehicle amongst investors. It is considered a high risk- high returns investment vehicle.
But the Bear Market Run carrying on since last year has been responsible for the erosion of capital of several investors. On a broader side, the returns depend on the financial health of the company (of which you have purchased the shares), the performance of that particular sector and the overall market performance in general.
On a narrower side (investors' side), the returns depend on investors' investment objectives, risk taking capacity and tenure of the investment. If the particular sector or company's shares are not performing well, the investors incur losses. Risk of losing money is high in case of equities due to volatile nature of markets.
Index Funds are a category of mutual funds which invest into a whole index [Sensex (30), Nifty (50)] rather than a specific stock. This strategy is also called ‘indexing’. The goal of most index funds is to follow the index performance. Index funds buy all the stocks of a particular index. This is a passively managed scheme.
The fund managers of these schemes do not get involved actively in shares selection and the process of investing. However, the volatility of markets (indices) is uncertain. The performance of the indices cannot be foreseen by any one. In India, the indices (Sensex, Nifty) are small as compared to US index of S&P 500.
Benefits of index funds
Economical: Indexing is a passive investing strategy; it does not involve any active management by the fund managers as in the case of the actively traded funds. The main objective of index funds is to reflect the performance of indices. The cost of analysts` salaries, research cost, and brokerage is saved in case of the index funds.
Better Performance: The performance of passive funds is likely to be better than actively or professionally managed funds. In the long run, any particular stock cannot beat the whole index performance.
For the week ended Mar. 20, 2009, Index funds were the biggest gainers among all classes of mutual funds with 3.16% gain as the 30 share index, Sensex rose 210.07 points, or 2.40%, to 8,966.68 in the week ended Mar. 20, 2009. On the other hand, the broad based NSE Nifty rose 87.8 points, or 3.23%, to 2,807.05 in the same period.
NAVs of the index funds category gained 3.16% in the week Mar. 20, 2009.
Among the index funds, Nifty Junior BeES gained 4.33%, Benchmark S&P CNX 500 Fund added 3.49%, J M Nifty Plus Fund rose 3.33%, LICMF Index Fund - Nifty Plan climbed 3.27%, Birla Sun Life Index Fund gained 3.24%. (Myiris).
Diversified Portfolio: Index funds invest in all stocks from different companies and different sectors of a particular index, leading to a wide range of stocks, which helps in the diffusion of risk.
Returns: Returns in index funds are largely dependent on the performance of whole indices; the Sensex and Nifty being benchmarks of the index funds` performance in India.
Saves time and money: The hard core research of specific stock or sector is not required in case of index funds as these funds track the performance of whole indices and not a stock and sector in particular. This saves time and money also as nothing comes free and research is not an exception.
Disadvantages of index funds
Market risk: When the market undergoes a fall, you also lose in case of index funds as these funds are entirely based upon the ups and downs of the market
Less Flexibility: Index funds lack in flexibility, as investors don’t get the opportunity to invest into stocks in that particular index. This is so because there is no scope of selecting stocks of personal choice, based on quality and research.
Conclusion:
To conclude, index funds can possibly offer higher returns in the longer period of time, subject to performance of indices or markets. Index funds thus seem to be a better option between the two, as their advantages considerably outweigh the disadvantages. Diversification, lower cost and maintenance give them an edge over individual stock picking.
Source: http://in.reuters.com/article/personalFinance/idINIndia-38898620090406?sp=true