Should You Buy Individual Stocks or Mutual Funds


 

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Many people say you should not buy individual stocks, and maybe they are right.  Buying individual stocks is radically different from buying mutual funds.  It takes a different mindset and it carries a completely different set of risks.  So what is the difference?

When you buy into a mutual fund, you are buying a large number of different stocks.  One of the most concentrated mutual funds you can buy is one that tracks the Dow Jones Industrial average (such as the DIA, or “diamonds”). which trades on the American Exchange.  In this case you are only buying into the Dow Jones Industrial Average, which includes 30 large, household-name companies.  There is also the Janus Twenty Fund that invests in just 20 stocks that the managers pick.  Otherwise, you’ll probably find that a listing of the holdings in your mutual fund will cover a few pages in the prospectus (a booklet that describes a mutual fund).   

Because you are buying so many stocks, your return over long periods of time will essentially equal that of the market in general, minus expenses, regardless of the mutual fund you pick.  Your return will be between 8-20% before expenses if you hold for ten or more years, and if you hold for more than  fifteen years, your return will narrow to between about 10-15%.  There will be years when you make 30 or 40% returns, and others where you’ll lose 20 or 30%.  On really bad years, you might lose 50% or more.  On great years, you might make 100%.

With a mutual fund, you’re protected against a single CEO making a big mistake and causing the company stock to lose 90% of its value.  You’re protected against choosing the wrong company and seeing your investment tread water while others are charging ahead.  You don’t need to spend a huge amount of time pouring over annual reports or earnings sheets.

Individual stocks are different.  Individual stocks routinely double in value or drop 50% in a year.  If you have only a few stocks, you may see your portfolio value change by  ten or twenty percent in a day.  There are also times when your stocks will fall in price even though everything seems fine at the company, or continue to rise for days on end without a clear reason why.  You might also see a company take on too much debt, misread the customers, or just become no longer needed and disappear entirely.  This doesn’t happen with mutual funds.

So why would someone buy individual stocks?  Again, most people shouldn’t.  Most people who try to trade individual stocks end up making much lower returns than the markets.  They buy too late, chasing the latest fads after the run-up has occurred, then hold on way to long as their stocks crash back down to earth.  Then they sell out, right at the bottom, when they should have been buying. 

Look at average returns, and you may see 3-4% when the market was making 15%.  For most people, if they would just buy index mutual funds (funds with low fees since they just buy whatever is in a particular stock index) and forget they own them, they would do much better.  In fact, everyone should do this for a portion of their portfolio if they have a portfolio of reasonable size (greater than $20,000, say).

There is a way to use individual stocks, however, for a portion of your investing that can allow you to beat the markets.  This is the way that Warren Buffett and Bill Gates made their billions.  You do it buy buying companies, rather than trading stocks.  Rather than worrying about the price of the shares and trying to time buys and sales to make a small profit, you find great companies and buy in for the long-term.  You plan to own them for the good times and the bad times as they grow and mature.  Twenty years down the road, they may be paying out as much in dividends each year as you paid for the shares.

This type of investing is very simple mechanically, but very difficult emotionally.  You need to be willing to sit there as your shares lose half of their value, perhaps buying more at the bottom.  There may be years when the markets go up 30%, but your company’s stock sits and does nothing.  The big gains are made in short bursts, with a lot of waiting in between.

Individual stock investing isn’t for everyone.  But for some, it can be the path to life-changing gains.  The secrets are patience, stock selection, and proper risk management.  Plus control of your emotions and a willingness to buy when everyone else is selling.  

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

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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.

5 thoughts on “Should You Buy Individual Stocks or Mutual Funds

Add yours

  1. “Index funds vs individual investment”

    The question is certainly interesting to point out, for every single investor that has the courage to go in the market, picking his own stocks, after doing his own research, and valuations.

    I think that if there was something to remind to individuals wishing to take in the stock market hunt by themselves is that this requires seriously strict behavioral condition. Unless they’re speculators, it is an activity that demands so much time, reading, search, patience and psychological control that it’s not made for everyone.

    The other path to investing in the stock market should then be by investing in a mutual fund indexing the DJIA as you said in your post. This will almost guarantee a correct return, at least the one the market offers, but the investor should also be aware of the different fees and taxes that are dependent on the mutual fund itself. This is why it’s important to choose wisely a mutual fund, if interested in.

    For the investors having a good time looking for great opportunities, this certainly is a great strategy to turn your investing returns around for the long term.

    Thank you for this post. It’s a reminder for individual investors to ask themselves the question “Am I wishing to do what it takes to outperform the market by myself or not?” Since when even portfolio managers have hard times getting over market returns, the question clearly should be reminded as often as possible.

    Please come visit my blog anytime. It’s about finding out economic moats: https://ivmoats.wordpress.com/

    To great investment opportunities,

    Regards

    Samir

    1. Thanks Samir for the great comment. I chose not to go into the intricacies of choosing mutual funds and looking at fees since I would make the post to long and complicated. That will be the topic for another day.

      I do want to say, however, that individual stock investing need not take much more time than mutual fund investing if you invest as I advise – buying into companies as if you were becoming a part owner in the business. When you invest this way, you really don’t need to watch your stocks very carefully because you’re not planning on selling anytime soon anyway. Once you gather your watchlist of companies (and there aren’t that many companies that would make the list), it is just a matter of reexamining them periodically and just choosing those priced best from your list when you have money to invest.

      1. I am just like you. I do prefer investing in the long way business ownership consideration. And precisely, I think you have to take the time to know the most things about the company investigated.

        If you buy a business, you want to own a whole lot of components such as debt, assets, management, etc, which requires some financial literacy.

        I think this has to be studied promptly so you can sleep well at night after making your call to buy. Then, you just have to wait for the time to compound your money. That’s what Warren Buffett calls “cash compounding machines”.

        If you manage to do all this quickly, I would definitely like to know more about your investing strategy. Because sometimes, going through all the requirements I need to check for my strategy and moats valuing, honestly this can take some time of investigation, that are worth because in the end, I can get stocks that are cheap relative to their intrinsic value with a sustainable return for the next 7 to 10 years or more. That’s my objective, and I think it’s a great way to get high returns over the long term.

  2. “You do it buy buying companies, rather than trading stocks. Rather than worrying about the price of the shares and trying to time buys and sales to make a small profit, you find great companies and buy in for the long-term.”

    This is the approach I’ve used for the past couple of years after being a hapless, losing “trader” for most of a decade. I must say that it’s been incredibly rewarding even in this short time, but you’re absolutely correct in that “This type of investing is very simple mechanically, but very difficult emotionally.” Being subscribed to a great investment advice service that preaches long-term buy-and-hold has made this much less emotionally difficult, so it’s important that an investor also finds good advice that correlates with their investing style, in my case long term.

    1. Thanks for the great comment, and congratulations on seeing “the light” and finding that long-term investing is how you actually do well in the stock market. It is actually the advantage individual investors have since they can just choose a few great stocks and hold them forever. A mutual fund manager needs to buy a whole basket of stocks and then sell if people start to leave the fund and he needs to raise cash. I went through a lot of different phases before landing there as well. Even now I find myself going back to some old habits every now and then.

      Unfortunately the last few years have been pretty good, market wise. We might see some bad years coming up that will test your resolve to buy and hold – it is hard to stay invested when you see your stock lose half of its value. While holding through (and maybe scooping up some more shares in the dips) is the right thing to do, many people give up hope and sell, often right at the low point. You just need to keep telling yourself that nothing has changed with the company and it will emerge stronger than ever with fewer competitors. Sometimes, just turning it all off and ignoring things for a few months also helps.

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