Stocks and index funds are two different types of investments that people can make to increase their wealth. While there are several similarities, there are also notable differences in how these two asset classes work and in the expected returns and risks associated with them.
The question at hand here, however, is: should you buy stocks or index funds when investing money in Belgium? To answer this question, one has to know what stocks and index funds are, after which we will discuss their characteristics and how these traits influence the expected returns an investor stands to gain from both options.
Index funds track specific indices like, for example, the S&P 500, which includes 500 large companies across a wide variety of industries. Even though each of these is heavily weighted in its respective industry, the index represents the whole economy when taken together.
When one invests in an index fund, there are no individual stocks that one is buying, which means that if you invest 10,000 dollars into an index fund, then all your money will be represented in each stock within the index fund.
This lack of diversification is that everyone can’t buy every single company available, so it would be hard to create a fund with an individual containing every company present in the market. This type of diversification isn’t needed, though, because all of these companies have similar characteristics, making them good substitutes for each other since they all fall within the same category.
On the other hand, when you buy stocks, you’re buying shares of a company which means that you own a tiny part of the company. Now there are two types of stock: common and preferred.
Preferred stock is similar to bonds because they promise payment at a specific date, but unlike bonds, they usually do not pay interest. Given this lack of interest, their price fluctuates with the market since investors will only buy them if they yield more than other debt instruments like treasury bills or corporate bonds.
However, the common stock does not come with such promises; instead, each share entitles its owner to one vote on every decision, whether it concerns paying dividends or undertaking mergers.
Given this right, common shares tend to be riskier investments; because without any guarantees, the company may choose to give dividends that are not consistent with their performance, or they can decide to take on hazardous endeavours that might result in bankruptcy.
This risk, however, comes with the prospect of high returns since if these odd ventures do succeed, then everyone will rejoice as the value of the stock goes up drastically.
It brings us to talking about investing money in the stock market itself. An index fund is pretty much investing your money into a passively managed mutual fund, whereas stocks are invested through active management, otherwise known as day trading.
Because of this difference, an index fund yields more consistent returns than buying individual stocks, which has a higher potential for gains and more volatility due to their speculative nature.
Also, because there are no actively traded stocks in an index fund, these funds charge lower fees than if one were to buy stocks; this will be reflected in the net returns you get from investing in such a fund.
Research has found that when investing money in the stock market, it is more advisable to buy index funds instead of individual stocks (check out Saxo for more info).
However, it doesn’t mean that index funds are without their downsides: they still carry the risk of having bad stocks within their portfolio, which would make even some of the best index funds lose value.
And amidst all this, there is still the fact that some companies don’t make themselves available for passive investors like mutual and exchange-traded funds and given this exclusivity, some people might want to have control over their investments than buying stocks provide.