Investing in Stocks
When you buy shares of stock in individual businesses, you become a part owner of the company. That means you should get a proportional share of the profits or losses depending upon how successful the business is. McDonald's corporation, for instance, earned $4,551,000,000 after taxes in profit last year. The company's Board of Directors decided to mail $2,465,300,000 of this back to the company's stockholders in the form of a cash dividend. This worked out to $2.44 per share. If you owned 1,000 shares, you received $2,440 in cash. If you owned 1,000,000 shares, you received $2,440,000 in cash.Investors who bought ownership in successful companies in the past have grown very rich. Imagine if you became part owner of Microsoft, Google, Berkshire Hathaway, Coca-Cola, Nike, eBay, Target, Disney, or American Express when they were small. As their profits grew, you benefited based upon the total ownership you held. In fact, a $10,000 investment in Wal-Mart when the company first issued stock to outside investors, has now grown to more than $10,000,000 with dividends reinvested!
On the other hand, companies fail. Sometimes, they slowly atrophy like the American car manufacturers. Other times, they end in a spectacularly catastrophic meltdown, like Enron. If you own stock in these companies, your shares might be worthless, just as if you owned a local bakery that had to shut its doors.
Investing in Index Funds
When you buy an index fund, you are really buying a basket of stocks designed to track a certain index, such as the Dow Jones Industrial Average or the S&P 500. In effect, investors who buy shares of an index fund own shares of stock in dozens, hundreds, or even thousands of different companies indirectly.Someone who invests in an index is basically saying, "I know I'll miss the Wal-Mart's and McDonald's of the world, but I will also avoid the Enron's and Worldcom's of the world. I just want to make money from corporate America by becoming part owner. My only goal is to earn a decent rate of return on my money so it will grow over time. I don't want to have to read annual reports and 10Ks."
Statistically speaking, 50% of stocks must be below average and 50% of stocks must be above average. This is why so many index fund investors are so passionate about passive index fund investing. They don't have to spend more than a few hours each year looking over their portfolio. Whereas an individual stock investor needs to be familiar with a company's business, its income statement, balance sheet, financial ratios, strategy and more.
Although only you and your qualified financial planner can decide which approach is best and most appropriate for your own situation, as a general rule, index fund investing is better than investing in individual stocks because it keeps costs low, removes the need to constantly study earnings reports from companies, and almost certainly results in being "average", which is far preferable to losing your hard earned money in a bad investment.
