Should I buy stocks in individual firms or only index funds?

Simple answer:

- Never buy stocks in individual firms unless you can prove you have a worthwhile, legal stock-picking advantage over professional fund managers (99% of people can't). Invest via a low-cost retirement (super) fund or if buying outside super, use Vanguard index funds.


But the Barefoot Investor said I can:

In the Barefoot Investor book Scott says:

"If you want some advice on which stocks to buy, you have two choices: head over to asx.com.au, where you can search for a ‘full-service broker' — that is, someone who'll recommend stocks. Alternatively (blatant plug alert), you can join our Barefoot Blueprint investment newsletter."

- Scott's advice here is wrong. Over 90% of professional stock pickers fail to beat the market after all costs over periods longer than 10 years. That includes the Barefoot Blueprint, which Scott Pape has now shut down.

- For amateur stock pickers more than 95% will fail to beat the market over periods longer than 10 years. If they accounted for the cost of their time and all related costs (e.g. tax) this proportion would be over 99%.


Long answer:

It's all about something called uncompensated risk. Read the full explanation here: > The Whitecoat Investor - Uncompensated risk Excerpts below.

- "A compensated risk is a risk, which, if you take, will increase the expected (not guaranteed) return of your portfolio.  An uncompensated risk is a risk which doesn’t increase, and may even decrease the expected return.  Why would anyone ever take an uncompensated risk?  Good question.  The truth is, you shouldn’t if you don’t have to.  Nobody does it knowingly.  So how do you avoid it?  Diversification.  An uncompensated risk is a risk that you can diversify against."

- "For example, you can invest your portfolio all in IBM stock.  Now, let’s imagine IBM has about the same expected return as the overall stock market, say 5% real per year.  Now, is it more risky or less risky to invest in just IBM or to invest in all 6000+ stocks in the US market?  Of course it is more risky to invest in IBM.  So shouldn’t the expected return of investing just in IBM be higher?  Nope, it doesn’t work like that.  Because you CAN diversify against that risk, you don’t get paid to take that risk.  You get paid for taking on market risk, but not to take on the risk of investing in a single company.  If you were paid to take on that risk for every little company in the stock market, then the overall stock market return would, of necessity, have to be higher."

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