Index Funds vs. Individual Stocks in a Transitioning Market

Thanks to years of quantitative easing, artificially low-interest rates and, more recently, a “Trump bump,” index funds have enjoyed a long winning streak, lulling investors into complacency while building their profile as an ideal, low-cost investment. However, the wild swings in the market this year have been unnerving for investors who hadn’t experienced such volatility for several years. And, the recent market selloff is a stark reminder to investors that there is risk in index funds.

Even more unnerving is the fact that a large portion of the performance of the S&P 500 index has been driven by just a handful of large, high-performing stocks – primarily technology. In particular, the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google/Alphabet) accounted for more than 38% of the gain in the S&P 500 index from its February 8 low through the end of July.1 It shouldn’t be surprising then, that this same group of stocks was the primary driver of the market selloff over the next few months.

What does this mean for index fund investors?

You’re not as Diversified as You Think

One of the main selling points of index funds is their ability to provide investors with instant diversification, which is key to minimizing risk. In theory, an investment in an S&P 500 index fund or ETF buys a stake in each of the 500 companies that comprise the index. While that may seem diversified, the reality is that the majority of the index’s performance is driven by a handful of stocks. For example, there were just 10 companies (the FAANG stocks in addition to Microsoft Corp. Visa, Inc., Mastercard, Inc., Adobe Systems, Inc., and NVIDIA Corp.) that accounted for more than 100% of the gain in the S&P 500 for the first half of the year.2

Unexpected Concentration Risk

This concentration of risk gets worse as more money flows into these index funds because fund managers are mandated to buy more shares of these over-weighted stocks, which drives their valuations even higher regardless of their fundamentals. This overvaluation introduces more risk, which could result in a larger fall during a steep market decline. This lack of breadth in the index should concern investors, especially when you consider that index funds, by design, are almost certain to suffer 100% of the next market correction.

Lack of Downside Protection

The significant disadvantage of index funds this reveals is the lack of downside protection. An investment in an index fund will give you the upside when the market is doing well, but it can leave you completely vulnerable to the downside. Unlike an individual stock portfolio, in which investors can control risk exposure, index investors have no opportunity to pare back their exposure to overvalued stocks, which can increase volatility beyond the comfort level of many index fund investors.

The Case for Individual Stocks

In a universe of nearly 9,000 companies with listed stocks, you would think there would be a good number sitting outside of the S&P 500 index that could be considered high quality without the bloated valuations. The key to stock selection is identifying well-managed companies with strong balance sheets selling at a deep discount to their intrinsic value. This not only raises the ceiling on their potential price appreciation, but it also raises the floor on potential price decreases. High-quality companies with high growth ceilings purchased at a fair value introduce less risk to a portfolio than overvalued companies regardless of their growth prospects.

While these stocks will probably never be “headline” stocks that drive market performance, they are less likely to lead a down market. While a portfolio of high quality, undervalued stocks may not always outperform the overall market during up years, it is more likely to outperform the market in down years. It’s in those down years, or any year with strong volatility, when investors win by not losing. When you string enough of those wins together with average gains in the up years, you can achieve stable, long-term returns without having to endure the risk component in the broader market, which is important to investors who are near or in retirement.

Building a successful investment portfolio today requires taking both a global view and a long view. With the right portfolio of stocks, selected for their quality, value and long-term growth prospects, all that is needed is the patience and discipline to adhere to a long-term investment strategy. S&P 500 dependence on FANG stocks grows as record nears. August 9, 2018. These 10 stocks account for all the S&P 500 first half gains. July 2, 2018.

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