Stocks vs Index trading: What’s the difference?

The beginning of a year is often the time when traders and investors reassess their strategies, reflecting on the gains they have made in 2021 and contemplating how the world – and stock markets – have changed.

This year, much like the past two, is filled with new uncertainty and a dynamic global economic backdrop that warrants an assessment of risk profiles, and one that will often come down to a key question: Is it better to buy indices or specific stocks?

Volatility, risk and return

An index fund is designed to track the performance of a particular market index, such as the S&P 500 or the FTSE 100. The main benefit is the reduced risk that comes with banking on a collection of several companies, typically indexed on the basis of size. 

The key difference between stocks and indices is that for the latter, shocks are smoothed, resulting in lower volatility. In times of economic expansion, as has been seen globally in the aftermath of the Covid-19 pandemic, indices can offer an easier path to realising broad market gains.

A big theme in the stock versus index debate is risk and return. Stocks can sometimes offer bigger gains. For traders, stocks provide higher volatility, yet require a closer eye on the company, and on the industry and economy in which it operates.

A number of analysts and traders spoke to Capital.com about the fortunes of stocks and indices this year, and what investors should contemplate as they decide to buy a stock or index fund.

Market moves together

Deciding whether to lump a majority of funds into individual stocks or index funds is also a technical question about how an investor prefers to manage risk, and the time they have available to do so.

“Given the time involved and expertise required, you can understand why many investors would rather save themselves the trouble and put their money into a tracker or an exchange-traded fund. This saves time,” said Russ Mould, investment director at AJ Bell.

Mould pointed out that indices allow both a reduction in the administrative headache of individual dealing and trading costs, as well as a contextual buffer of reducing exposure to risk in a given industry, sector or geography.

“Some indices are very exposed to just a select number of stocks or industries and if they go wrong, the investor may find themselves unwittingly exposed here, unless they carry out careful study first,” he said.

Andrew Aziz, founder and CEO of Peak Capital, can see why index trading became the optimal investment strategy during the height of Covid-19.

“The majority of the market moves together and it is thus harder to find stocks in play. Even if your scanner identifies what at first glance might appear to be a strong stock in play, there may very well still be more opportunities to be had in trading index funds.”

Easier to predict and react

But Mould cautioned against backing indices without giving consideration to wider factors, particularly as the number of indices on offer grows.

“The number of indices has proliferated over the past few years and many offer exposure to very narrow themes,” he said. “These can work well but they can also go wrong and leave the investor owing something which is riskier than it looked.”

The diversity on offer could also lead to complacency, particularly given the rise of tracker indices, including exchange-traded funds (ETFs), which follow the market. If managed poorly, the difference between stocks and indices can count for little to the investor’s balance sheet..

“Trackers can tempt investors to reach beyond their normal risk parameters by enabling them to buy something that would have perhaps been beyond their reach otherwise, such as emerging or frontier markets, or a specific theme or industry,” Mould added.

“And ultimately an index will not go up all of the time – a tracker or ETF will do a good job of following an index up, but it will follow it down just as efficiently.”

The benefits of stocks, Mould argues, stem from the fact that, when closely monitored, they can perhaps be easier to predict and react to than large, varied indices.

“This can be achieved by identifying a key industry trend – in the view that a bad stock in a good sector will tend to outperform a good stock in a bad sector – or a macro shift or something that is company specific and leads to inflection point in sales, profits, cash flow and ultimately sentiment toward the stock.”

Picking the right moment

When comparing stock with indices, Peak Capital’s Aziz stressed that timing was important in stock picking, particularly when the market is quiet and stocks are more susceptible to endogenous shocks. 

In particular, Aziz noted that earnings seasons, which typically occur every three months, can be a good time to dive into stocks.

And in waiting for broader industrial trends to take hold, Aziz argues, the investor may be left waiting for the right timing.

“There are many reasons why a sector will suddenly experience volatility. When bitcoin mania began in 2017, and then again later in 2020, semiconductor companies, blockchain companies, and crypto miners became very attractive to traders,” said Aziz.

“But it is important to remember that the crypto sector, indeed all sectors, are not always volatile, and for months, even years, a particular sector may not provide the volatility or liquidity that traders are constantly looking for.”

Aziz highlighted that while typically preferring to trade in stocks, particularly through busy earnings seasons, through the pandemic he invested more heavily in indexes and sectors centered on travel, technology, work-from-home companies, and vaccine and Covid-19 treatments.

A bumper year for indices, but is trouble looming?

2021 continued the trend of accelerating indices across the globe on the back of government-backed stimulus that straddled consumption and investment, spearheading unprecedented rebounds in aggregate demand. 

An October 2021 outlook by the World Economic Forum (WEF) projected gross domestic product (GDP) growth for developed economies of 5.2%, and 6.4% for developing ones. That booming international growth has been apparent in the world’s biggest index funds.

In the last year, four major US indices pleased investors with generous returns. The Dow Jones Industrial Average (DJIA), S&P 500 (SPX) and the tech-focussed US Tech 100 Composite Index (NDX) delivered 17.65%, 40.9% and 15.29% annual gains, respectively. 

But with that growth has also come the return of inflation and the onset of monetary tightening in Western economies to stem excess demand, amplified in the face of sustained global supply chain issues. 

“Since the Covid-driven selloff in the first quarter of 2020, we’ve seen index investors fare very well, particularly in the United States with the S&P 500 rallying more than 110%,” said Victoria Scholar, head of investments at Interactive Investors.

In turn, banks and forecasters are still projecting positive returns in the stock market. JPMorgan’s 5050 price target for the S&P 500 index in 2022 represents a 6.9% increase on current values, a steep downgrade from the 2021 return of 26.9%. 

Adding complexity to the stock trading vs index trading debate, Andrew Sheets of Morgan Stanley, thinks the index could contract by 5%. In light of expectant deceleration, many analysts believe the question is becoming one less focused on what to invest, but where.

Geographical divergences becoming more important

While most global economies are in a similar period of post-Covid, the macroeconomic and industrial responses are divergent cross-country, and complicate the argument of investing in stock vs indices.

Indeed, inflation looks set to continue to be the main story across developed economies. The US recently reported its fastest rate of inflation since 1942, increasing by 7% in the 12 months to December 2021, compared to 5% in the eurozone, while the UK saw prices increase by 5.1% in the 12 months to November 2021. 

Japan, meanwhile, only experienced a marginal increase in prices of 0.6%. In China, prices increased by 1.5% in the 12 months to December 2021.

“On top of that, Japan enjoys high vaccination rates so is relatively protected versus other economies against the threat of Omicron and other variants. Plus, the Nikkei looks undervalued versus the S&P 500 so could potentially play catch up in 2022, having lagged behind last year,” said Scholar.

Those favouring indices may do well to focus on Asia in 2022, or look more closely into specific stocks that could benefit from Chinese and Japanese stimulus.

Anthony Cheung, head of market analysis at Amplify Trading, reinforced the idea that the stocks versus indices debate has no overall winner, with geography and divergent government policy likely to shift the risk profiles of these investment options over 2022.

“The exit from the pandemic in 2022 is also likely to contribute to significant differences in geographic performance as policy divergence in both monetary and fiscal policy widens.”

Note that predictions can be wrong. Forecasts shouldn’t be used as a substitute for your own research. Always conduct your own due diligence before investing. And never invest or trade money you cannot afford to lose.

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