Googling ‘Best Stocks to Buy’? You Need an Index Fund

Investing, Investing Strategy, Investments
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Here’s a hot tip on the best stock to buy right now: There isn’t one.

Sure, there are some well-known performers. Amazon just celebrated 20 years since its IPO; the stock has posted a 36% compounded annual gain in the years since. It has appeared on countless lists of best stocks to buy, and rightly so.

But what investors scouring the internet to buy stocks frequently don’t understand is that a return like that is the exception, not the norm. On the whole, individual stocks fail to perform, much less outperform the diversified portfolio provided by an index fund.

The futile search for the best stock

In a working paper from this year, Hendrik Bessembinder, a professor of finance at Arizona State University, asks: “Do Stocks Outperform Treasury Bills?” The answer he found: Over their long-term holding periods, while some stocks trump one-month Treasurys, most do not. For context, one-month Treasury bills are returning less than 1% annually, and have been for some time.

In fact, Bessembinder finds that more than half of common stocks deliver negative lifetime returns. The entire net gain of the U.S. stock market since 1926, he says, can be attributed to just 4% of listed stocks.

So how do you narrow down to those scarce winners? Looking backward, that’s easy. You might be able to name a few of the stocks on that list just from an occasional glance at CNBC — Amazon is in that group, as are Apple, Exxon Mobil, General Electric, IBM and Microsoft, according to Bessembinder’s research.

Looking forward to find the next hot thing, however, is harder. That’s not only because predicting performance is a job even the pros haven’t mastered — Snapchat, anyone? — but also because the best stocks for your portfolio aren’t necessarily the best stocks for someone else’s portfolio. Your goals, risk tolerance, current holdings and budget will vary, and those are key considerations when purchasing any investment.

It’s important to remember that by time you hear about the next hot prospect — particularly if you found it via a Google search — so, too, have many other investors, which means its potential is surely already reflected in its price.

Like Amazon, it could outperform expectations. But cases like Amazon’s are exceedingly rare. There are countless other promising companies — you may remember Pets.com or eToys — that have already faded quietly into nonexistence, often yielding the outcome most common for individual stocks in Bessembinder’s analysis: a lifetime loss of 100%.

» Want to learn more about evaluating stocks? Read about how to research a stock.

Why an index fund is the answer for many

While individual stocks may rarely turn out to be winners, when they come together into a diversified portfolio, they have a lot of power. In fact, they blow Treasurys out of the water: The Standard & Poor’s 500, an index of 500 of the largest companies in the U.S., has posted an average annual return of nearly 10% since 1928, compared with an under-4% return from three-month Treasurys over the same time period.

That’s why low-cost index funds and exchange-traded funds, which bundle a number of stocks into one product, should form the basis of a long-term portfolio. They do all the work for you — within a fund’s range of stocks, the winners balance out the losers, and you don’t have to forecast which is which. With an S&P 500 index fund, for example, you’ll buy one fund that aims to mirror the performance of the S&P 500. To do that, the fund invests in the companies that make up that index.

Managing expectations

Index funds won’t beat the market. They aren’t supposed to, and the expenses you pay for investing in the fund will drag down returns slightly, just as transaction fees like commissions drag down stock trading returns.

An index fund’s goal is to match the returns posted by its benchmark — in the example above, that benchmark is the S&P 500, but there are funds that track a range of underlying assets, from the total stock market to international stocks, bonds and commodities such as gold. The goal is to put together several of these funds to build a balanced, diversified portfolio that takes the appropriate amount of risk for your age.

Each fund is also inherently diversified, at least among the segment of the market it tracks, so while there are still risks involved, index funds are significantly less risky than attempting to pick a few could-be winners out of a lineup of stocks. They’re also, some might argue, significantly less thrilling. If you’re still seeking that stock-picking rush, go for a happy middle ground: Dedicate 10% or less of your portfolio to predicting the next big thing, and use index funds for the rest.

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.