Why is the dominant investing advice for individuals to use mutual funds, exchanged traded funds (ETFs), etc
"Great question! While investing in individual stocks can be very useful as a learning experience, my opinion is that concentrating an entire portfolio in a few companies' stock is a mistake for most investors, and especially for a novice for several reasons. After all, only a handful of professional investors have ever beaten the market over the long term by picking stocks, so is it really worth trying? If you could, I'd say go work on Wall Street and good luck to you. Diversification For many investors, diversification is an important reason to use an ETF or index fund. If they were to focus on a few sectors or companies, it is more likely that they would have a lop-sided risk profile and might be subject to a larger downside risk potential than the market as a whole, i.e. ""don't put all your eggs in one basket"". Diversification is important because of the nature of compound investing - if you take a significant hit, it will take you a long time to recover because all of your future gains are building off of a smaller base. This is one reason that younger investors often take a larger position in equities, as they have longer to recover from significant market declines. While it is very possible to build a balanced, diversified portfolio from individual stocks, this isn't something I'd recommend for a new investor and would require a substantial college-level understanding of investments, and in any case, this portfolio would have a more discrete efficient frontier than the market as a whole. Lower Volatility Picking individual stocks or sectors would could also significantly increase or decrease the overall volatility of the portfolio relative to the market, especially if the stocks are highly cyclical or correlated to the same market factors. So if they are buying tech stocks, they might see bigger upswings and downswings compared to the market as a whole, or see the opposite effect in the case of utilities. In other words, owning a basket of individual stocks may result in an unintended volatility/beta profile. Lower Trading Costs and Taxes Investors who buy individual stocks tend to trade more in an attempt to beat the market. After accounting for commission fees, transaction costs (bid/ask spread), and taxes, most individual investors get only a fraction of the market average return. One famous academic study finds that investors who trade more trail the stock market more. Trading also tends to incur higher taxes since short term gains (<1 year) are taxed at marginal income tax rates that are higher than long term capital gains. Investors tend to trade due to behavioral failures such as trying to time the market, being overconfident, speculating on stocks instead of long-term investing, following what everyone else is doing, and getting in and out of the market as a result of an emotional reaction to volatility (ie buying when stocks are high/rising and selling when they are low/falling). Investing in index funds can involve minimal fees and discourages behavior that causes investors to incur excessive trading costs. This can make a big difference over the long run as extra costs and taxes compound significantly over time. It's Hard to Beat the Market since Markets are Quite Efficient Another reason to use funds is that it is reasonable to assume that at any point in time, the market does a fairly good job of pricing securities based on all known information. In other words, if a given stock is trading at a low P/E relative to the market, the market as a whole has decided that there is good reason for this valuation. This idea is based on the assumption that there are already so many professional analysts and traders looking for arbitrage opportunities that few such opportunities exist, and where they do exist, persist for only a short time. If you accept this theory generally (obviously, the market is not perfect), there is very little in the way of insight on pricing that the average novice investor could provide given limited knowledge of the markets and only a few hours of research. It might be more likely that opportunities identified by the novice would reflect omissions of relevant information. Trying to make money in this way then becomes a bet that other informed, professional investors are wrong and you are right (options traders, for example). Prices are Unpredictable (Behave Like ""Random"" Walks) If you want to make money as a long-term investor/owner rather than a speculator/trader, than most of the future change in asset prices will be a result of future events and information that is not yet known. Since no one knows how the world will change or who will be tomorrow's winners or losers, much less in 30 years, this is sometimes referred to as a ""random walk."" You can point to fundamental analysis and say ""X company has great free cash flow, so I will invest in them"", but ultimately, the problem with this type of analysis is that everyone else has already done it too. For example, Warren Buffett famously already knows the price at which he'd buy every company he's interested in buying. When everyone else can do the same analysis as you, the price already reflects the market's take on that public information (Efficent Market theory), and what is left is the unknown (I wouldn't use the term ""random""). Overall, I think there is simply a very large potential for an individual investor to make a few mistakes with individual stocks over 20+ years that will really cost a lot, and I think most investors want a balance of risk and return versus the largest possible return, and don't have an interest in developing a professional knowledge of stocks. I think a better strategy for most investors is to share in the future profits of companies buy holding a well-diversified portfolio for the long term and to avoid making a large number of decisions about which stocks to own." No. You're lucky, maybe, but not really a successful investor. Warren Buffet is, you're not him. Sometimes it is easier to pick stocks to bid on, sometimes its harder. I got my successes too. It is easier on a raising market, especially when it is recovering after a deep fall, like now. But generally it is very hard to beat the market. You need to remember that an individual investor, not backed by deep pockets, algo-trading and an army of analysts, is in a disadvantage on the market by definition. So what can you do? Get the deep pockets, algo-trading and an army of analysts. How? By pooling with others - investing through funds. Why is that? With all the successful investors (including myself on a not-infrequent basis) going for individual companies directly, wouldn't it make more sense to suggest that new investors learn how to analyse companies and then make their best guess after taking into account those factors? I have a different perspective here than the other answers.  I recently started investing in a Roth IRA for retirement. I do not have interest in micromanaging individual company research (I don't find this enjoyable at all) but I know I want to save for retirement. Could I learn all the details? Probably, as an engineer/software person I suspect I could. But I really don't want to. But here's the thing: For anyone else in a similar situation to me, the net return on investing into a mutual fund type arrangement (even if it returns only 4%) is still likely considerably higher than the return on trying to invest in stocks (which likely results in $0 invested, and a return of 0%). I suspect the overwhelming majority of people in the world are more similar to me than you - in that they have minimal interest in spending hours managing their money. For us, mutual funds or ETFs are perfect for this. I agree with the other answers, but I want to give a slightly different perspective. I believe that a lot of people are smart enough to beat the market, but that it takes a lot more dedication, patience, and self-control than they think. Before Warren Buffett buys a stock, he has read the quarterly reports for years, has personally met with management, has visited facilities, etc. If you aren't willing to do that kind of analysis for every stock you buy, then I think that you are doing little more than gambling. If you are just using the information that everyone else has, then you'll get the returns that everyone else gets (if you're lucky). Cost.  If an investor wanted to diversify his portfolio by investing in the companies that make up the S&P 500, the per-share and commission costs to individually place trades for each and every one of those companies would be prohibitive. I can buy one share of an exchange-traded fund that tracks the S&P 500 for less than the purchase price of a single share in some of the companies that make up the index. "I'll give the TLDR answer. 1) You can't forecast the price direction. If you get it right you got lucky. If you think you get it right consistently you are either a statistical anomaly or a victim of confirmation bias. Countless academic studies show that you can not do this. 2) You reduce volatility and, importantly, left-tail risk by going to an index tracking ETF or mutual fund. That is, Probability(Gigantic Loss) is MUCH lower in an index tracker. What's the trade off? The good thing is there is NO tradeoff. Your expected return does not go down in the same way the risk goes down! 3) Since point (1) is true, you are wasting time analysing companies. This has the opportunity cost of not earning $ from doing paid work, which can be thought of as a negative return. ""With all the successful investors (including myself on a not-infrequent basis) going for individual companies directly"" Actually, academic studies show that individual investors are the worst performers of all investors in the stock market." "Funds - especially index funds - are a safe way for beginning investors to get a diversified investment across a lot of the stock market. They are not the perfect investment, but they are better than the majority of mutual funds, and you do not spend a lot of money in fees. Compared to the alternative - buying individual stocks based on what a friend tells you or buying a ""hot"" mutual fund - it's a great choice for a lot of people. If you are willing to do some study, you can do better - quite a bit better - with common stocks. As an individual investor, you have some structural advantages; you can take significant (to you) positions in small-cap companies, while this is not practical for large institutional investors or mutual fund managers.  However, you can also lose a lot of money quickly in individual stocks. It pays to go slow and to your homework, however, and make sure that you are investing, not speculating. I like fool.com as a good place to start, and subscribe to a couple of their newsletters. I will note that investing is not for the faint of heart; to do well, you may need to do the opposite of what everybody else is doing; buying when the market is down and selling when the market is high. A few people mentioned the efficient market hypothesis. There is ample evidence that the market is not efficient; the existence of the .com and mortgage bubbles makes it pretty obvious that the market is often not rationally valued, and a couple of hedge funds profited in the billions from this."
The main difference between an ETF and a Mutual Fund is Management. An ETF will track a specific index with NO manager input. A Mutual Fund has a manager that is trying to choose securities for its fund based on the mandate of the fund. Liquidity ETFs trade like a stock, so you can buy at 10am and sell at 11 if you wish. Mutual Funds (most) are valued at the end of each business day, so no intraday trading.  Also ETFs are similar to stocks in that you need a buyer/seller for the ETF that you want/have. Whereas a mutual fund's units are sold back to itself. I do not know of many if any liquity issues with an ETF, but you could be stuck holding it if you can not find a buyer (usually the market maker). Mutual Funds can be closed to trading, however it is rare. Tax treatment Both come down to the underlying holdings in the fund or ETF. However, more often in Mutual Funds you could be stuck paying someone else's taxes, not true with an ETF.  For example, you buy an Equity Mutual Fund 5 years ago, you sell the fund yourself today for little to no gain. I buy the fund a month ago and the fund manager sells a bunch of the stocks they bought for it 10 years ago for a hefty gain. I have a tax liability, you do not even though it is possible that neither of us have any gains in our pocket. It can even go one step further and 6 months from now I could be down money on paper and still have a tax liability. Expenses A Mutual Fund has an MER or Management Expense Ratio, you pay it no matter what. If the fund has a positive return of 12.5% in any given year and it has an MER of 2.5%, then you are up 10%. However if the fund loses 7.5% with the same MER, you are down 10%. An ETF has a much smaller management fee (typically 0.10-0.95%) but you will have trading costs associated with any trades. Risks involved in these as well as any investment are many and likely too long to go into here. However in general, if you have a Canadian Stock ETF it will have similar risks to a Canadian Equity Mutual Fund. I hope this helps. "Of course. ""Best"" is a subjective term. However relying on the resources of the larger institutions by pooling with them will definitely reduce your own burden with regards to the research and keeping track. So yes, investing in mutual funds and ETFs is a very sound strategy. It would be better to diversify, and not to invest all your money in one fund, or in one industry/area. That said, there are more than enough individuals who do their own research and stock picking and invest, with various degrees of success, in individual securities. Some also employe more advanced strategies such as leveraging, options, futures, margins, etc. These advance strategies come at a greater risk, but may bring a greater rewards as well. So the answer to the question in the subject line is YES. For all the rest - there's no one right or wrong answer, it depends greatly on your abilities, time, risk tolerance, cash available to invest, etc etc." It's very simple. The low cost index funds are generally the best investments for investors, but - because of the low fees and the fact that the offerings of different companies are nearly identical - they are the worst for the investment houses. Therefore, the investment houses spend a lot of money convincing investors to choose other funds.  If you remember that investment houses are all in the business of making money for themselves, not for the investor, then the whole financial system will make much more sense. "I actually love this question, and have hashed this out with a friend of mine where my premise was that at some volume of money it must be advantageous to simply track the index yourself. There some obvious touch-points: Most people don't have anywhere near the volume of money required for even a $5 commission outweigh the large index fund expense ratios. There are logistical issues that are massively reduced by holding a fund when it comes to winding down your investment(s) as you get near retirement age. Index funds are not touted as categorically ""the best"" investment, they are being touted as the best place for the average person to invest. There is still a management component to an index like the S&P500.  The index doesn't simply buy a share of Apple and watch it over time.  The S&P 500 isn't simply a single share of each of the 500 larges US companies it's market cap weighted with frequent rebalancing and constituent changes.  VOO makes a lot of trades every day to track the S&P index, ""passive index investing"" is almost an oxymoron. The most obvious part of this is that if index funds were ""the best"" way to invest money Berkshire Hathaway would be 100% invested in VOO.  The argument for ""passive index investing"" is simplified for public consumption.  The reality is that over time large actively managed funds have under-performed the large index funds net of fees.  In part, the thrust of the advice is that the average person is, or should be, more concerned with their own endeavors than they are managing their savings.  Investment professionals generally want to avoid ""How come I my money only returned 4% when the market index returned 7%?  If you track the index, you won't do worse than the index; this helps people sleep better at night. In my opinion the dirty little secret of index funds is that they are able to charge so much less because they spend $0 making investment decisions and $0 on researching the quality of the securities they hold.  They simply track an index; XYZ company is 0.07% of the index, then the fund carries 0.07% of XYZ even if the manager thinks something shady is going on there. The argument for a majority of your funds residing in Mutual Funds/ETFs is simple, When you're of retirement age do you really want to make decisions like should I sell a share of Amazon or a share of Exxon?  Wouldn't you rather just sell 2 units of SRQ Index fund and completely maintain your investment diversification and not pay commission?  For this simplicity you give up three basis points?  It seems pretty reasonable to me." In my opinion, the ability to set a sell or buy price is the least of my concerns.  Your question of whether to choose individual stocks vs funds prompts a different issue for me to bring to light. Choosing stocks that beat the market is not simple. In fact, a case can be made for the fact that the average fund lags the market by more and more over time. In the end, conceding that fact and going with the lowest cost funds or ETFs will beat 90% of investors over time. I still don't see the point of this software; rebalancing frequently is a waste of money (through fees).  If you invest in index funds, you don't have to rebalance at all--effectively, the fund is doing it for you, and since they can generally trade more efficiently than individual investors can, that's a win.  The Coverdell ESA is a great example.  There's a maximum contribution amount, just as there are for almost any tax-exempt account.  A decent financial adviser could help you plan how much to contribute to which accounts, at what time, and when you can/should start to withdraw from them. For what it's worth -- and I realize this isn't directly an answer to the question -- one of the advantages of sticking with mutual funds, beyond their being inherently diversified, is that it removes a lot of the temptation to try to time the market. When you need money, you sell shares in such a way that it maintains your preferred investment ratio, and simply don't worry about which stocks are  actually involved. (I've gotten 15% APR this year across all my investments, for absolutely minimal effort. That's quite good enough for me.) Wikipedia has a fairly detailed explanation of ETFs.  http://en.wikipedia.org/wiki/Exchange-traded_fund "Your question is one of semantics.  ETFs and mutual funds have many things in common and provide essentially the same service to investors with minimal differences.  It's reasonably correct to say ""An ETF is a mutual fund that..."" and then follow up with some stuff that is not true of a typical mutual fund.  You could do the same with, for example, a hedge fund.  ""A hedge fund is a mutual fund that doesn't comply with most SEC regulations and thus is limited to accredited investors."" As a matter of practice, when people say ""mutual fund"" they are talking about traditional mutual funds and pretty much never including ETFs.  So is an ETF a mutual fund as the word is commonly used?  No." "There's a huge difference between ""can an anverage person make a profit on the stock market"" and ""can an average person get rich off the stock market"". It is certainly possible for an average person to profit, but of course you are unlikely to profit as much as the big Wall Street guys.  An S&P 500 index fund, for instance, would be a pretty good way to profit.  People with high-powered tools may make a lot of money picking individual stocks, and may even make some choices that help them when the market is down, but it's difficult to see how they could consistently make money over the long term without the S&P 500 also going up.  The same applies, to varying extents, to various other index funds, ETFs, and mutual funds. I agree with littleadv that there is no single ""right"" thing for everyone to do.  My personal take is that index funds are a good bet, and I've seen a lot of people take that view on personal finance blogs, etc. (for whatever that's worth).  One advantage of index funds that track major indexes (like the S&P 500) is that because they are and are perceived as macro-indicators of the overall economic situation, at least you're in the same boat as many other people.  On one level, that means that if you lose money a lot of other investors are also losing money, and when large numbers of people start losing money, that makes governments take action, etc., to turn things around.  On another level, the S&P 500 is a lot of big companies; if it goes down, some of those big companies are losing value, and they will use their big-company resources to gain value, and if they succeed, the index goes up again and you benefit. In other words, index funds (and large mutual funds, ETFs, etc.) make investing less about what day-trading wonks focus on, which is trying to make a ""hot choice"" for a large gain.  They make it more about hitching your wagon to an extremely large star that is powered by all the resources of extremely large companies, so that when those companies increase their value, you gain.  The bigger the pool of people whose fortunes rise and fall with your own, the more you become part of an investment portfolio that is (I can't resist saying it) ""too big to fail"".  That isn't to say that the S&P 500 can't lose value from time to time, but rather that if it does go down big and hard and stay there, you probably have bigger problems than losing money in the stock market (e.g., the US economy is collapsing and you should begin stockpiling bullets and canned food)." A few months ago, I met with the founder of Wealthsimple. As someone with higher than average about both trading and investing, I asked him whether his funds would be able to add more value to my Couch Potato portfolio not in terms of returns but rather in terms of management fees. I also asked him this: if I wish to have a portfolio that has a specific % allocation towards emerging markets, would I be able to do so with Wealthsimple. The answer to both of the above questions was that I'd be better off investing by myself. I'd venture a guess and say that most people on SE Money wouldn't require a service such as Wealthsimple. "As already noted, options contain inherent leverage (a multiplier on the profit or loss). The amount of ""leverage"" is dictated primarily by both the options strike relative to the current share price and the time remaining to expiration. Options are a far more difficult investment than stocks because they require that you are right on both the direction and the timing of the future price movement. With a stock, you could choose to buy and hold forever (Buffett style), and even if you are wrong for 5 years, your unrealized losses can suddenly become realized profits if the shares finally start to rise 6 years later. But with options, the profits and losses become very final very quickly. As a professional options trader, the single best piece of advice I can give to investors dabbling in options for the first time is to only purchase significantly ITM (in-the-money) options, for both calls and puts. Do a web search on ""in-the-money options"" to see what calls or puts qualify.  With ITM options, the leverage is still noticeably better than buying/selling the shares outright, but you have a much less chance of losing all your premium. Also, by being fairly deep in-the-money, you reduce the constant bleed in value as you wait for the expected move to happen (the market moves sideways more than people usually expect). Fairly- to deeply-ITM options are the ones that options market-makers like least to trade in, because they offer neither large nor ""easy"" premiums. And options market-makers make their living by selling options to retail investors and other people that want them like you, so connect the dots. By trading only ITM options until you become quite experienced, you are minimizing your chances of being the average sucker (all else equal). Some amateur options investors believe that similar benefits could be obtained by purchasing long-expiration options (like LEAPS for 1+ years) that are not ITM (like ATM or OTM options). The problem here is that your significant time value is bleeding away slowly every day you wait.  With an ITM option, your intrinsic value is not bleeding out at all. Only the relatively smaller time value of the option is at risk. Thus my recommendation to initially deal only in fairly- to deeply-ITM options with expirations of 1-4 months out, depending on how daring you wish to be with your move timing." "If anything, the price of an ETF is more tightly coupled to the underlying holdings or assets than a mutual fund, because of the independent creation/destruction mechanism. With a mutual fund, the price is generally set once at the end of each day, and the mutual fund manager has to deal with investments and redemptions at that price. By the time they get to buying or selling the underlying assets, the market may have moved or they may even move the market with those transactions. With an ETF, investment and redemption is handled by independent ""authorized participants"". They can create new units of the ETF by buying up the underlying assets and delivering them to the ETF manager, and vice versa they can cancel units by requesting the underlying assets from the ETF manager. ETFs trade intraday (i.e. at any time during trading hours) and any time the price diverges too far from the underlying assets, one of the authorized participants has an incentive to make a small profit by creating or destroying units of the ETF, also intraday." ETrade allows this without fees (when investing into one of the No-Load/No-Fees funds from their list). The Sharebuilder plan is better when investing into ETF's or stocks, not for mutual funds, their choice (of no-fees funds) is rather limited on Sharebuilder. First, it's not always the case that ETFs have lower expenses than the equivalent mutual funds.  For example, in the Vanguard family of funds the expense ratio for the ETF version is the same as it is for the Admiral share class in the mutual fund version.  With that in mind, the main advantages of a mutual fund over an equivalent ETF are: From a long-term investor's point of view, the main disadvantage of mutual funds relative to ETFs is the minimum account sizes.  Especially if the fund has multiple share classes (i.e., where better classes get lower expense ratios), you might have to have quite a lot of money invested in the fund in order to get the same expense ratio as the ETF.   There are some other differences that matter to more active investors (e.g., intraday trading, options, etc.), but for a passive investor the ones above are the major ones.  Apart from those mutual funds and ETFs are pretty similar.  Personally, I prefer mutual funds because I'm at a point where the fund minimums aren't really an issue, and I don't want to deal with the more fiddly aspects of ETFs. For investors just starting out the lower minimum investment for an ETF is a big win, as long as you can get commission-free trades (which is what I've assumed above.)