Anyone who has money they won’t need to touch for several years needs to invest in equities (stocks) to prevent the loss of their savings due to inflation. Likewise, anyone who wishes to become wealthy should consider stock investing as a way to magnify their earning ability. By investing, one can gain income in exchange for allowing others to use their capital and by doing so grow net worth at a rate that is much greater than most people can earn through simply working.
There are two ways that investors can participate in the stock market – by buying stocks directly and through mutual funds. Deciding which way is appropriate for you depends on several factors including your time available to research investments, your tolerance for volatility, your investment objectives, and your interest and ability to pick stocks.
Buying individual stocks means selecting from the thousands of choices available the small basket of stocks one would like to own. It also means deciding when to buy, and probably more importantly, when to sell. Buying individual stocks means being able to control one’s emotions and determining the best choices for a position while prices are moving up 100% or down 50% in a single year or even a period of a few weeks. It also requires more study to learn the mechanics of putting in trades, the nuances of things like ex-dividend dates, and more bookkeeping when it comes to income taxes.
By buying stocks directly, one can outperform the market. Instead of buying all ten of the stocks in a market sector, you can pick just the top one. If you have a talent for sorting out the good businesses from the bad, you can do much better than the market return. You also have the advantage that you don’t need all of your picks to be good, just one or two to be great.
There are certainly advantages to mutual funds as well, however. In buying a mutual fund, one is pooling her money with that of thousands of other investors. That pool of money is then used to buy 100, 200, 500, or even 1000 different stocks or more. Buying mutual funds gives automatic diversification, which will reduce the chance of losses and generally reduce the amount of volatility so that the value of your portfolio will be more stable. While there are years when the market will move up or down 40%, most years will result in swings of 20% or less. Also, while buying mutual funds guarantees only matching the market, minus fees and expenses, mutual funds are easily bought, and once purchases require almost no maintenance at all.
Given the choice between individual stocks or mutual funds, one should buy mutual funds if most of the following are true:
1. You tend to be worried by large fluctuations in your portfolio value. If a drop of 20% would cause you to sell and hide under a rock, individual stocks aren’t for you. If you would take advantage of the lower prices to buy more shares, you have the right psychology.
2. You don’t have the desire to learn about the markets or do the research needed to find good stocks. Many people have other things that they would rather be doing than reading the Wall Street Journal and Money Magazine. If this is true of you, maybe mutual funds would be a better choice.
3. You don’t have time to do the research to find good stocks. Because mutual funds are the market, finding good mutual funds requires a lot less time than finding good stocks. Granted, once you have found a basket of good stocks the time required to maintain the portfolio drops dramatically, so long as you are investing for the long-term, but it does take an initial investment of time.
4. You have a lot of money. The more money you have, the more important it is to have the proper diversification to reduce the chances of a large loss. A person who has $2000 to invest can well afford the loss of the $2000 in a single stock, provided he is raising money from his salary and investing regularly. A person with $1 million cannot afford a loss of the whole $1 million from large positions in a few stocks. A good portion of that money, say 50%, should be in mutual funds. Another portion, say 30%, should be in several large, solid, dividend paying stocks and bonds. The remainder can be in larger position in individual growth stocks, if desired. As one’s wealth grows, a portion should be diverted into mutual funds. That portion should grow with the value of the portfolio.
5. You can’t leave things alone. People who are constantly trading will never make money in individual stocks. If you find yourself constantly watching CNBC, unable to stick to a position for long periods of time, you would be better off buying mutual funds and using some of the proceeds each year to fund a trip to Vegas. At least that way you’ll get a change of scenery and drinks will be included.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.