I am a fan of index funds. By owning every stock in a particular market index, these funds provide broad diversification and keep fees low because there’s no need to pay a high-priced manager to pick stocks or determine when to sell them. The funds must buy all of the stocks (or bonds) in the index and keep them until a stock (or bond) is booted from the index. Of course, you’re never going to beat the market with an index fund. But you’ll get a near-market return, and the returns of the stock market aren’t half bad over long stretches of time.
But I’m writing this column about picking individual stocks because I firmly believe investors should not live by index funds alone. That’s because buying individual stocks forces you to look at numbers that index fund investors often ignore. Immersing yourself in these numbers can give you an important edge when the markets act irrationally, which they do pretty much all of the time. You can use that edge to manage your entire portfolio, not just your individual stocks.
When you buy an index fund, you’re likely to focus on just one number—the performance of the index. Index funds are set-it-and-forget-it investments, so you’re not analyzing market fundamentals. If the index is up, you’re happy. If it’s down, you’re concerned. But the index tells you where you’ve been, not where you’re going.
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When you buy individual stocks, however, you’re looking at price-earnings ratios, dividend yields, company growth rates and so on. These numbers don’t tell you much about where a stock has been, but they give you a good idea of where a company is heading. By looking at many stocks, you get a picture of where the entire market is going, too.
At pivotal turning points, it’s particularly important to focus on the future, not the past. Consider, for example, what was going on in 1999. Anyone who was focusing on indexes couldn’t be talked out of buying—especially stocks of big companies. It is easy to see why. Over the previous 20 years, Standard & Poor’s 500-stock index had returned 17.9% annualized. And over the previous five years, the returns were even better: 28.6% annualized, according to Morningstar’s Ibbotson unit.
But if you were focusing on individual stocks, you saw a starkly different picture. Stocks were selling at incredibly inflated prices—often at P/Es that were two to ten times the underlying companies’ projected earnings growth rates. A good rule of thumb to avoid overpaying for a stock—the key to earning a good return—is to compare a stock’s P/E with the company’s growth rate and dividend yield. If the P/E is less than the sum of the growth rate and the yield, the stock is likely a bargain; if the P/E is much higher, the stock is probably overpriced. (For more on my approach, check out my February 2012 column.)
In early 1999, I couldn’t find reasonably priced stocks. The ones I owned looked pricey, too. So I sold most of my individual stocks and shifted my 401(k) assets out of the U.S. market and into funds that invested in foreign companies. (I thought I was too young to shift into bonds, although that might have been a better course of action.) The move was about a year too early. But you know what happened next: The S&P 500 lost 47% from March 2000 to October 2002.
Today, the story is reversed. People who focus on the S&P 500 are demoralized. Over the past ten years, their returns have barely kept pace with inflation; over the five years that ended December 31, 2011, the market lost money.
But look at key measures of individual stock values today and you’re likely to be optimistic. Many healthy, cash-rich companies are selling at bargain-basement prices. Remember: The reason you’re investing is to provide for the future, and individual stocks make you look in that direction.
Kathy Kristof is a contributing editor to Kiplinger’s Personal Finance and author of the book Investing 101. You can see her portfolio at kiplinger.com/links/practicalportfolio.
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