Why (Index) Mutual Funds are More Likely than Individual Stocks to Provide Gains over Shorter Periods of Time

In Using Investing to Build Up Cash for Large Purchases  it was recommended that mutual funds be used instead of individual stocks to build up money for an eventual large purchase.  This may seem an odd choice since the potential returns from individual stocks are much higher than those from mutual funds, meaning you would have the opportunity build up a balance faster invested in individual stocks than you would invested in mutual funds.  It also seems to go against the serious investing concept cited in other posts where funds are concentrated when you have little money, and therefore growth is more important that preserving your investing funds, and then diversified out into more and more stocks as balances grow because prevention of a large loss is needed to avoid losing ground once you actually have something to protect.  Indeed, a big advantage that individual investors have over mutual fund managers is the ability to select a few great stocks rather than buying everything.  This provides the possibility for individual investors to beat the markets while the mutual fund manager can match index returns at best before fees.

The difference in this case, however, is that the investor was trying to build up cash in a relatively short period of time.  True investing is a long-term proposition.  If you’re buying individual stocks you want to find companies that are well run and have room to grow.  You then need to buy in and prepare to hold them for years as the company grows and expands its business.  There are all kinds of fluctuations in the price of the stock as other individuals trade the shares based on different strategies, hopes, fears, and events in their lives.  There will also be good and bad news for the company related to the ups and downs in the economy.  There were a lot of great companies that lost seventy-five percent of their value in 2008, only to come back to their former levels in 2009 and 2010.  These kinds of fluctuations are unpredictable and part of investing.  It is the long holding periods that put the odds in the favor of the investor and make individual stock investing profitable.

In this case investing was being used to magnify what could be built up through hard work and saving with the goal of getting a large amount of cash in four, five, or maybe six years.  This could be the down payment for a home, or some cash for a new (preferably two to four year-old) car, or maybe some cash to supplement other savings for college expenses.  As discussed in the previous post, this is not true investing since the time period is not long enough to be assured of a good (or even positive) return, but instead being opportunistic and waiting for the value to increase due to a l-timed move up in the markets, then using the opportunity to sell.  This could occur in a short period of time or it may take a few extra years.  You are just giving yourself the opportunity to shorten the amount of time it will take to raise the money through work and saving alone by using stocks.

The issue in using individual stocks in this scenario is that there is a lot of volatility in the price of individual stocks.  This means that a portfolio made up just a few individual stocks will change in value very rapidly, possibly doubling or quadrupling in value, of falling by 75% or more, in a single year.  It is also very possible, and probably more likely, that a portfolio made of just a few individual stocks may do nothing in a given year, not really changing in value at all.  This is because individual stocks grow in spurts, shooting up tens to hundreds of percentage points in a period of a few weeks to a couple of months. It may then sit there for several months or maybe even a couple of years before making any other moves.

As an example, I’ve held shares of Home Depot since the mid 1990’s, buying in at prices ranging from the $50’s to the $20’s, building up a fairly sizable number of shares.  While there were fits and spurts, the stock went nowhere all through the 1990’s and 2000’s.  (For a long-term chart of the share price, go here.)  Then, in 2011, the stock started to shoot up.  At this point the stock is around $115, meaning about a 200% increase from my cost basis.  This is a rate of return of between 8 and 10%, with things currently looking bright for future gains in share price.  This compares with a rate of return of about 5% for the S&P500 index over the same period of time.  This is a good return, but it was along wait before anything happened.

Buying index funds instead, the ups and downs would have been less severe.  More importantly, the natural drift of the markets is up, so if I had kept buying shares in an index fund as I went, I would expect to see at least some positive gain within a few years since I’d be buying during both peaks and troughs in the value of the index fund.  Over long periods of time, I could do better by picking stocks and holding them (assuming I am a good stock picker) that I would do invested strictly in mutual funds.  Over shorter periods of time, however, I am more likely to have a positive investment return, adding to my work and savings, if I invest in index funds than if I were to pick individual stocks.

Got something to say?  Have a question?  Please leave a comment or contact me at vtsioriginal@yahoo.com.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.


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