Most financial planners will tell individuals to always use mutual funds, and in many cases, they are right. If you look at the returns of the average mutual fund manager and compare it to the returns of market benchmarks like the S&P500 or the Dow Jones Industrial Average, you’ll find that very few managers beat either index over a period of many years. The reasoning then goes, if a professional money manager with all sorts of degrees, experience, and a staff to help him research stocks can’t beat the market, how could an individual?
We’ve now reached Step 7 in the steps to investing: Deciding between using mutual funds and investing directly. This is the point where you decide if you want to invest only through mutual funds, or if you want to put in a little more time and invest in individual stocks to try to do a little better than the markets.
Professional managers therefore need to buy a lot of stocks they don’t really want. They buy their first pick, their second pick, and maybe all the way down to their tenth pick in a given industry. Really they end up buying the whole market, so the best they can do is to match market performance. Actually, they won’t even do that because of the salaries and expenses they have to pay that comes out of the return generated by the fund.
As an individual investor, you don’t have that issue. You could put all of your money in your top pick and then do really well if it outperformed the market. Given that there are only a handful of stocks that outperform the market over long periods of time, concentration can be a good thing. You can also put your money in a few stocks and hold them as they grow and expand. This means you won’t need to pay capital gains taxes until you sell, where you will need to pay taxes on gains inside mutual funds if the manager sells shares even if you don’t sell shares of the mutual fund.
The risk is that you pick a few stocks, but your choices are bad. This could mean a few of the companies go bankrupt, wiping out your entire investment, or just that they don’t do as well as the rest of the market. If you pick badly, you would have been better off just buying a mutual fund.
So the answer really is to either just buy mutual funds, and funds that have the lowest cost possible since that will result in the greatest return, or to buy a few individual stocks to provide the possibility of getting a home run and putting the rest of your investments into mutual funds. If you don’t want to spend any time at all worrying about your investments, just go the mutual fund route. If investing is something that interests you, maybe buy a few individual stocks and see where it leads you.
Note that unless you’re self-employed, you’ll mainly be invested in mutual funds anyway. This is because 401K plans, HSA plans, and the government employee counterparts, generally don’t allow you to invest in individual stocks. If you are putting away 10-15% of your paycheck into retirement, as you should, you’ll already be putting most of your investments into mutual funds. You can then use the $300-$500 per month you can save in addition to retirement investing to buy individual securities and not worry about jeopardizing your future through some bad investments. Most of your money will be in mutual funds in your retirement plans, which will also ensure you a comfortable retirement so long as you don’t do something stupid like cash out the plan, so you can take the risk of not doing so well picking individual stocks and bonds.
Another factor in deciding between just mutual funds and a combination of funds and individual stocks is how you plan to invest. If you are planning to try to time the markets, buying and selling several times a year or even several times a day, I can guarantee you that you’d be better off just investing in mutual funds. While it can be entertaining, the odds of you correctly timing your moves for a long period of time are almost zero. Any news that comes out is already priced into the shares before you can hit the buy or sell button. Any idea you have about the prospects for a company because of a product coming out has already been had by a thousand people and they have priced the shares appropriately.
To make it worth the trouble, you need to buy companies for the long-term. You want to find the next Microsoft or Home Depot and buy it while it still has a lot of room to expand. Then, you want to hold it for long periods of time while it grows and grows. You don’t want to make $1000 from the quick sale of a company stock that went up by $10 per share over the period of a few months. You want to earn $100,000 over the period of ten years from a stock that went up 500%.
If you learn what to look for, you can find these companies and buy in. Then it is just a matter of waiting for them to do well. You don’t need to get the timing right. You don’t need to worry about the effect of a financial crisis somewhere in the world or some new policy the government puts out that affects the markets for a few weeks or months. You can wait through any of these things until the value of the company you invested in is realized. The other great thing about investing this way is that the stocks you are right about that go up 500% will make up for the ones that you were wrong about. if you buy five stocks and one doubles in price twice, you will break even even if the four other stocks go bankrupt.
So, sticking with just mutual funds or adding a few individual stocks to your portfolio is a personal choice. If you don’t want to spend any time to learn how to pick stocks, there is nothing wrong with buying mutual funds. If you can’t leave things alone and will always be buying and selling, just put your money in some mutual funds and then plan a trip to Las Vegas. But if you are willing to spend a little time learning about investing and stock picking, and have the patience to buy into some great companies and then just wait, there are definitely greater rewards than can be had.
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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.