It is much easier to make money from trading indices than it is to make money from trading individual stocks over the long run. That’s because it’s much easier to predict the direction of the broad stock market’s index (e.g. S&P 500) than it is to predict the direction of individual stocks.
What you need to do when trading the broad index (e.g. S&P 500)
When you trade the index, you only need to predict where the overall stock market is going in the future (up vs. down).
A nation’s stock market moves in the same direction as its economy.
- If the nation’s economy is improving, then its stock market will go higher in the long term (even though there will be some short term fluctuations along the way).
- If the nation’s economy is deteriorating, then its stock market will go down in the long term (even though there will be some short term fluctuations along the way).
People who trade/invest in the whole index don’t need to care about individual stocks because no single stock is big enough to have a meaningful impact on the whole stock market. For example, Apple is big. But Apple only accounts for a tiny percentage of the overall U.S. stock market (approximately 4% of the entire U.S. stock market). So no matter what Apple’s stock does, it will not have a significant impact on the overall U.S. stock market.
This chart demonstrates that the stock market (S&P 500) rarely makes big declines (bear markets, which are 40%+ declines) outside of recessions.
*Recessions are in grey, bear markets are in orange. This is a log scale chart.
Why trading individual stocks is harder
A lot of random and exogenous events impact individual stocks. You cannot consistently and accurately predict these events before they happen. These events can cause the stock to spike or tank in 1 day.
Individual stocks are impacted by the broad stock market AND the company’s own factors. Hence, individual stock traders need to focus on 2 things (predict the broad stock market and understand the individual company’s factors), whereas index traders only need to focus on 1 thing (predict the broad stock market).
The less things you have to predict, the easier it is to trade.
- If the company itself is doing well but 95% of other individual stocks are crashing, then the company’s stock will probably fall as well.
- If the company itself is doing poorly but 95% of other individual stocks are soaring, then the company’s stock will probably rise as well.
This was commonly seen during 2008, when the overall U.S. stock market crashed.
This is the S&P 500 in 2008. Notice how most of the U.S. stock market crashed.
Because the entire U.S. stock market crashed, even terrific companies that were making a lot of profits saw their stock prices fall.
For example, Apple’s stock fell in 2008 because the whole stock market was crashing, even though Apple made a ton of profits in 2008. (Apple’s business was doing great in 2008, but its stock price still tanked).
Study after study has shown that the vast majority of people are terrible at picking stocks. So if you’re trading individual stocks, realize that there’s a high probability that over the long run, the money you make from trading individual stocks will probably be less than the money you make from trading indices.
The godfather of stock picking – Ben Graham, said that stock picking doesn’t work anymore. From Henry Blodget:
Most stock pickers believe that they are among the tiny minority of investors who can beat the market after costs, and, for inspiration and encouragement, they point to legends such as Warren Buffett and Benjamin Graham. What such investors often don’t know is that even Buffett has said that the best strategy for most investors is to buy low-cost index funds and that the great Benjamin Graham eventually changed his mind about the wisdom of traditional stock-picking. In 1976, shortly before his death, Graham told the Journal of Finance the following:
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when [the bible of fundamental stock analysis, Graham and Dodd’s Security Analysis] was first published; but the situation has changed. I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost.
What did Graham mean when he said that “the situation has changed”? Why did he conclude—more than three decades ago—that stock-picking practices that had defined intelligent investing in the 1930s were, by the 1970s, no longer worthwhile?
First, in the seven decades since Graham wrote Security Analysis, the stock market has gone from being a playground for amateurs to a battlefield dominated by full-time professionals. One result is that pricing errors that once might have gone unnoticed for months in Graham’s day are now discovered and exploited instantly. Second, the amount of information available about the most obscure stock today dwarfs what was available about even the bellwethers a half-century ago, making it harder to dig up information that other investors don’t know. The moment the information is released, moreover, it is dissected, discussed, and debated by thousands of analysts, until most reasonable conclusions that can be drawn from it have been.
So why do people still trade individual stocks if they know the risk?
Because they let their greed get to them.
They think (and are encouraged by many trading “gurus”) that they are smart enough to identify the next 10,000% Amazon stock. They think they will be able to trade penny stocks and make 3% a week. (That’s >100% a year, which is ridiculous. No one can make 100% a year over the long run. Just ask anyone who actually works in the investment industry.)
Sure, some people do make 100% a year during bull markets. But when the next bear market comes (which it always does), the trigger-happy traders and investors lose 90% of their money. These are the same people who made a fortune in the dot-com bubble and then lost a fortune in the dot-com crash. As Warren Buffett said, “it’s only when the tide goes out do you see who is swimming naked.”
Trading individual stocks is fun. You get the rush of feeling like you’re on a treasure discovery journey, using a magnifying glass trying to find the next hot stock.
But ask anyone who has been in the markets for more than 15 years, and they’ll tell you that over the course of their trading career, the excess money they made trading some individual stocks was offset by the money they lost trading other individual stocks. On balance, they were no better off than trading indices. The only difference is that they spent a lot of time trying to pick individual stocks.
How do you trade indices
As we explained before, indices like the S&P 500 are:
a MEASUREMENT of a basket of stocks. The stock index is created and electronically calculated (second by second) by a big financial company that specializes in creating indexes (e.g. Standard and Poors).
As you can see, an index is merely a measurement of a basket of stocks. You cannot directly buy and sell an index because an index is merely a number/calculation.
If you want to invest in an index, you must trade index ETFs (exchange traded funds). These exchange traded funds are like stocks. An index ETF’s sole purpose is to track the movements of a designated index.
For example, $SPY is the S&P 500’s index ETF. $SPY is a fund that tracks the S&P 500.
- If the S&P 500 index goes up 1%, $SPY will go up 1%
- If the S&P 500 goes down -1%, $SPY will go down -1%
ETFs make trading an index very simple. If you want to trade an index like the S&P 500 directly, you would have to buy all 500 stocks in the S&P 500. An index ETF like $SPY does that for you. You merely buy a share in the index ETF.
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