He had the best of intentions. But he was stepping into a minefield.
This weekend, my friend Aaron told me he’s finally ready to start investing in “the stock market.”
As we enjoyed an easy run through the trails in a local national park, Aaron told me his plans.
“It’s past time for me to grow up and act responsibly with my money. Now that my career is stable and I’m getting some big bonuses, I need to plan for the future. So the next time I get a big check, I’m going to immediately put it into an index fund.”
I cringed when I heard the last part.
Aaron was trying to do the right thing. And I never want to discourage people from using the stock market to help generate more wealth.
But an index fund?
Aaron had no idea what kind of risk he would be taking!
Since I’m no longer licensed to give individual investment advice, all I could do was recommend Aaron to do his homework.
Hopefully, he’ll take some time to read through Rich Retirement Letter archives to see some of the better opportunities that the market offers.
But in light of my conversation with Aaron, I wanted to make sure you don’t make the same mistake!
So today, I’m going to explain to you why index funds can be very dangerous, especially in today’s market.
And I’ll give you three stocks to buy right now instead of investing in one of these dangerous funds.
Related: Great News for 3 of My Favorite Retirement Plays!
The Hidden Danger of Index Funds
Index funds have become extremely popular over the last decade or so.
Financial advisors have become fond of telling their clients that there’s simply no way to buy individual stocks and expect to outperform the market.
And so these Wall Street professionals simply steer their clients into index funds that track the broad market.
This advice leaves these professionals with a lot less responsibility to find good investments for their clients. It also leaves them a lot more time to spend on the golf course.
But that’s a conversation for another day.
The primary benefit of an index fund is that investors theoretically get a lot of diversification from just one investment.
In a perfect world, an index fund would take positions in a broad assortment of different companies.
And that way if one area of the market was weak, other areas would likely perform better.
By diversifying into many different areas of the market, an index fund would help investors take less risk with their retirement.
But that’s not the way index funds work today.
Thanks to the popularity of some of Wall Street’s biggest tech stocks, index funds are now heavily weighted toward large-cap technology plays.
You see, index funds are weighted to reflect the total market value of each company in the index.
So large companies represent a much bigger portion of the index than smaller companies — even if the larger companies are in similar areas of the market and have more risk of a pullback.
If you buy a popular index fund today that tracks the S&P 500 (the primary U.S. stock benchmark), you’ll actually be taking a very concentrated position in large-cap tech stocks.
That position was all well and good when shares of Amazon, Facebook, Alphabet and even Tesla were trading higher.
But now that those expensive stocks are starting to come under pressure, index funds are becoming much riskier.
And my concern is that we’re in the very early stages of a major shift away from large-cap tech stocks.
This move could cause a lot of pain for investors who think they’re safe by holding these risky index funds.
If You MUST Buy an Index Fund…
I understand the reason that some individual investors opt for index funds. Not everyone enjoys looking at individual companies and picking out the best stocks to buy.
I still think that your best option is to buy shares of quality companies that generate reliable profits and can pay dividends that grow over time.
It’s fine if you want to buy a fund that you can hold in your account without doing any additional research.
But please don’t buy a traditional index fund.
Instead, consider an equal-weight index fund — especially in today’s market environment.
An equal-weight index fund takes money from investors and puts it in all of the companies covered by an index.
So for a fund using the S&P 500 as its benchmark, the capital from the fund would be divided equally between all 500 stocks in the index.
This is a much better way to spread your investments into different areas of the market.
And today, the advantage of an equal-weighted index fund is even better!
That’s because we’re starting to see a trend of more money flowing into smaller companies and away from the bigger mega-cap tech stocks.
So by purchasing an equally weighted fund like the Invesco S&P 500 Equal Weight ETF (RSP), you’ll be allocating more of your dollars into smaller companies that have more potential for growth!
Of course, I’d still prefer to see you buy individual shares of some of the best stocks on Wall Street.
That’s why today, I wanted to share three of my favorite stocks for you to get started with.
My Three Favorite Stocks for New Investors
If you’re just getting started investing in stocks individually (or if you’re a veteran investor looking for some high-quality positions) here are my three favorite picks to help you jump in!
A great position to start with right now is Rio Tinto Group (RIO).
The company mines important resources like iron ore, aluminum, copper, uranium, silver, gold, diamonds and more.
As the global economy reopens, these resources are going to be in high demand.
Government stimulus and global infrastructure programs will lead to a lot of demand for the base metals that RIO produces.
And concerns about inflation will cause the company’s precious metals and diamond business to be more profitable.
If you buy shares of RIO today, you’ll be locking in a lucrative 5.6% yield.
And you’re buying the stock at a fairly cheap price, paying just $10.20 for every dollar of expected annual earnings. (As a comparison, the equal-weighted S&P 500 is paying about $25 for every dollar of expected earnings.)
My second recommendation is The Blackstone Group (BX). This is one of my favorite long-term investments because the company has one of the strongest business models around.
BX is a private equity company. That means Blackstone takes money from investors and puts it to work in various opportunities.
It then gets paid by charging fees for managing the investments and by generating returns when it invests its own capital alongside its clients.
I’ve always been impressed by the talented investors at BX and the returns the company has generated over time.
And while the dividends you receive from your BX shares will fluctuate based on the company’s profits, the most recent calculation put the dividend yield near 3.4%.
Not bad while you wait for your shares to trade higher!
Finally, I’d consider picking up shares of AT&T (T) today.
While this stock may not seem like an exciting play, it has a tremendous amount of potential to grow your wealth.
AT&T is a great play on the rollout of 5G networks and should benefit as more customers upgrade services to take advantage of faster 5G speeds.
It helps that AT&T partners with Apple to sell iPhones and other devices to customers.
If you buy shares of T today, you’ll be locking in a tremendous 6.9% dividend yield.
And you’ll be buying your shares at a relatively cheap price, paying just $9.30 for every dollar of expected earnings.
There’s a lot of room for shares of T to trade higher over the next several months. And it’s tough to beat the company’s dividend yield!
So if you’re interested in jumping into the market like my friend Aaron, please consider these three stocks instead of an index fund.
I believe this approach will give you a much better chance of success while helping you avoid the mega-cap tech risks you get with a traditional index fund.
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