Why Should You Buy Individual Stocks Instead of Just Buying Mutual Funds?


The Bogleheads’ Guide to Investing is truly a great book and one that you should read if you want to get involved in investing and to improve your financial life in general.  It includes information on mutual fund investing, budgeting, and what kinds of insurance you should have.  It also includes a lot of good information on research that has been done showing things like that the average investor would be better off just buying index mutual funds than managed mutual funds since most index funds outperform managed funds over time.  Likewise, it favors investors using mutual funds instead of individual stocks for the same reason – on average, most investors do better just buying index mutual funds than they do buying individual stocks.Now I have always been an individual stock (and bond, and warrant, and convertible) investor, probably because my father was an individual stock investor.  Of course, I started before index funds really existed.   Mr. Bogle started Vanguard and introduced the world to index funds back in 1976 with the start of the Vanguard S&P 500 Index fund, but back in 1984 when I started investing the fund was relatively small and there was little talk of index mutual funds, so I hadn’t heard of it.  I did buy a few closed-end mutual funds during that period, such as Tri-Continental Corp and Adam’s Express, but I was mainly invested in several individual stocks, taking up positions of 100 shares at a time.

There are really two purposes to a mutual funds.  The first is to allow small investors to spread their money out over several stocks, and thereby eliminate the risk that they would be substantially hurt should one of the companies in which they invest have an issue, for example, if the CEO defrauds the company or a company grossly misreads the markets and ends up closing down a lot of stores and going bankrupt.  I’ve had both things happen since I’ve been investing and I can affirm that you effectively lose your whole position when they do occur.  If you had your whole retirement savings in thee companies and one of them has an issue like this, you would see 1/3rd of your money disappear in a day.  If you have only a few stocks and even if nothing big happens, but a company stock simply flounders around for ten years and goes nowhere, you still have missed ten years of potential appreciation on your money.  You should have seen your money at least double in that time period, meaning you would have half as much money at retirement as you could have had.  This is why individual investors need diversification.

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The second reason for investing in mutual funds is to have an expert investor manage your money for you.  You pay an expert to do the research and pick the stocks for you, decide when to invest, and keep tabs on things.  You have fund companies like Janus who claim to have all sorts of insight and access to information that will allow them to make the best picks and do far better than you could do investing alone with your limited resources, or so the sales brochure says.

The trouble with this second idea is that professional money managers with managed mutual funds do not outperform the markets on a regular basis.  Various studies have shown both that investors would do better using index funds or simply throwing darts at a dart board much of the time.  This is because managers don’t outperform the markets with their picks or their market timing, instead maybe matching the performance of the markets at best.  You then do worse than the markets in a managed mutual fund due to the trading and research costs, especially if you include the fees they charge each year whether they beat the markets and make you money or not.


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So going back to the first question, why would anyone buy individual stocks instead of just buying index mutual funds?  If the pros can’t beat the index funds, what chance would an individual investor have?  The thing is, while there are few if any managed mutual funds that beat the index funds, there are individual investor who do so, and there are enough of them to make it more than just a fluke.  In fact, Warren Buffett, who has been the richest man in America at various times in the past, made his fortune by picking individual stocks.

The secret lies in the way you buy individual stocks, taking advantage of something an individual can do and a professional money manager at a mutual fund cannot – concentrate your holdings in a few great stocks and hold for long periods of time.

Concentrate your holdings.

By concentrating your holdings, while subjecting yourself to the single-stock risk discussed earlier, you are giving yourself the opportunity to make a real significant gain when you are right.  Professional money managers can’t do this because they have so much money to invest.  If they tried to put all of their money in just a handful of stocks, they would end up driving the price up and owning the companies.  An individual can buy 500, 1000 or even 2000 shares without the market even noticing.

If you own a large position and the CEO does jump town for Rio and the company goes bankrupt, you might be out $10,000 or $20,000 by doing this, but if you have a company that doubles a few times over a ten-year period, you can make $50,000 or even $100,000 if you have a lot of shares.  One success makes up for a couple of failures.


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Hold for a long period of time

  A professional money manager is constantly having her performance compared with the markets and other money managers.  Some managers even go out and buy whatever stocks did well right before the quarterly or annual report comes do to make it look like they had all of the hot stocks during the period. This adds to cost and means that they are buying stocks when they have already gone up in price.

Individuals can buy shares in a company and then just wait for the company to grow and do well, eventually catching the eye of the markets.  I sat on Home Depot stock through the late 1990’s and early 2000’s while the stock went nowhere.  Eventually they traded out CEOs and started to grow again.  Over the last few years, they have gone from $18 per share to about $190, which means that over the 20-year period they have returned about 12% annualized, compared with an 8% return for the S&P 500. If you were to look at my performance on that stock back in 2009, you would have only seen the stock go from about $18 to $20 over the 12-year period and I would have probably been fired if I were a fund manager.  It is only in the last ten years that the stock has greatly outperformed the markets.

So the bottom line is that individuals would be just fine buying only index mutual funds and the vast majority of investors should do so.  You’ll outperform managed funds and earn a good return on your money.  Every investor should have index mutual funds as the core holdings in their 401k plans, IRAs, educational IRAs, and other places where they really need to make sure the money will grow over time and be there when they need it.  Some investor, however, could also be well-served to add a couple of individual stocks, bought in high concentrations (at least 500 shares but never consisting of more money than one would be willing to lose) and held for long periods of time to their investment accounts outside of their core mutual-fund holdings.  I think there is still a role there for individual stocks.

New to investing? Want to learn how to use investing to supercharge your road to financial freedom?  Get the book: SmallIvy Book of Investing: Book1: Investing to Grow Wealthy

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

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.

How Long Would It Take to Be A Millionaire


 

How long would it take you to becoming a millionaire?  Well, I used an investment calculator to determine at what age you would become a millionaire if you invested different amounts, from $200 per month to $1000 per month, starting at age 20.  Here’s the results:

Monthly Savings 10% Return 15% Return
$200.00 59 49
$500.00 50 43
$750.00 46 40
$1,000.00 43 38

So if you put $200 per month away ($2400 per year) into stocks and saw another period like the 1980’s and 1990’s, you would become a millionaire somewhere in your early 50’s.  If you put away $1,000 per month, or $12,000 per year, you would become a millionaire at age 43 even if you just got modest, average returns from the markets.  If you could get a 15% return, you’d be there are age 38, just 18 years later.

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Note that $12,000 per year for 18 years is $216,000, which is what you could easily pay at a private, four-year college.  If you then left the money invested, and were able to earn 12% annualized, you would have a cool $12M at retirement with no effort on your part.  On the other hand, if you earned $200,000 per year at a job because you went to an elite college from age 20 to age 65, you would earn only $9M over your working lifetime.  Just saying….

Be sure to check out this month’s book, The Bogleheads’ Guide to Investing.  

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

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.

Ways to Maximize Your 401k Returns


Basic 401k investing is easy and can be done with a target date fund or by calculating your growth/income split and investing in a total stock market fund and a total bond market fund.  (For details, see Simple Ways to Invest in your 401k.)  If you take this road, you can have yourself in good shape when retirement time rolls around while spending maybe 5-10 hours over your whole life setting things up and making adjustments.  This is predicated on your putting away 10-15% of your paycheck each month into your 401k.  Money doesn’t magically appear without an investment.

But what if you’re willing to spend a little more time learning and twiddling with your account.  How can you really maximize your returns?  If you take the basic route, you’re probably going to end up making an annualized return somewhere between 8 and 10% over your working lifetime.  Optimize things and you may get between 10 and 12%.  How much does an extra 2% matter?  At 8%, investing $400 per month, you’ll end up with $2.3 M between starting work at age 20 and retirement at age 67.  At 10%, you’ll have $4.6 M.  If you could get 12% or 15%, you’d have $9.1 M and $26.1 M, respectively,  Would you spend an extra couple of hours per year to gain between $2 M and $24 M?  I sure would!

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Now that I’ve got you interested, what are the things to do to maximize your returns?  Well, here they are:

1.  Don’t overwork things.

Normally, this would be the last item discussed, but it is so important it needs to be said up front.  Doing a little bit of adjusting and fine-tuning is good, but constantly moving money around will reduce your returns to the point where you may not even get the 6% to 8% you would get in a target date retirement fund.  It is best to accept that you cannot time the markets and that you do not know anything that is not already priced into the markets at any given time.  It is best to continue to follow the same strategy regardless of what the markets are doing.

2.  Concentrate in stocks.

Adding bonds will reduce the level of volatility in your account, but it will also reduce your returns since bonds do not perform as well as stocks over long periods of time.  When you get close to retirement age, or if bond yields climb into the teens because of high-interest rates, taking up a bond position makes sense.  Between the ages of 16 and 55, especially with yields at current levels which are near all-time lows, staying in all stocks, or maybe all stocks and REITs, is the way to go.

 

 


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3.  Overweight small

Small companies have room to grow because they are small.  It is far easier for the pizza place down the street with three locations to double their store count and their earnings than it would be for McDonald’s to do the same.  For this reason, small stocks will do a little better over long periods of time than will big stocks.  Over any given year or period of three years is anyone’s guess, since sometimes large-caps outperform and other times small-caps outperform.

4. Go international.

The US is a great place to invest due to stability and good property rights, but it is not the only game in town.  There will be times when international markets perform better.  You should, therefore, include some international stocks in your portfolio.

5.  Stick with indexes.

Study after study has shown that all stock funds perform about the same with the only real difference being the fees that are charged and expenses due to trading inside of the fund.  You, therefore, get the best returns when you find funds that have low costs and do not trade very often, which means you want unmanaged funds.  Index funds fit the bill.


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Given the rules above: Don’t overwork things, 2) Concentrate in stocks, 3) Overweight small, 4) Go international, and 5) Stick with indexes, an optimized portfolio for someone between the ages of 16 and 55 might look like the following:

Large-cap index fund (e.g., S&P500 index fund) 30%

Small-cap index fund (e.g., Vanguard Small-Cap Index) 40%

International stock fund (e.g., Vanguard Total International Stock Index) 20%

REIT Fund (e.g., Vanguard REIT Fund) 10%

You would set up your contributions to follow the percentages shown above.

Over time it is likely that one or two of the funds would outperform the others for short periods of time.  For example, during a stock market slump the REIT might hold its ground or even increase while the stock funds decrease.  That might make the portfolio overweighted in the REIT, with the portion in the REIT at 15% instead of the targeted 10%.   To correct this, go into the portfolio a couple of times per year and rebalance by shifting money from those funds that are overweighted into those that are underweighted.  Often mutual fund companies have tools to allow you to adjust your investments to match your contribution percentages in just one click, so all you need to do is find the right button on their website.

When you are rebalancing, what you are doing is selling funds that have done well (selling high) and buying those that have not done as well (buying low).  This is exactly the opposite of what you are doing when you look through the choice of funds in your 401k plan and pick those that have done the best over the last year or five years or buy the funds that have the most stars at Morningstar, but this is what most people do.  This is why it is important not to try to time the market or chase the hot funds.

Note that you do not want to rebalance too often since rallies tend to lift stocks well beyond justifiable levels and declines tend to lower price below reasonable levels.  This is called momentum, where investors buy stocks because they are going up and sell them because they are going down.  Rebalancing once or twice a year is about right. Good dates to pick are just after the new year (since stocks tend to rally at the end of the year as year-end bonuses get invested) and in the late spring since markets tend to do nothing in the summer months while people are on vacation.  Late fall is another possibility since big declines tend to happen in September or October.

You might also rebalance after the market has had a big run-up and started to lose steam, or after a big drop once prices have started to stabilize.  You’ll never get things perfect, so don’t expect to sell at a top or buy at a bottom.

New to investing? Want to learn how to use investing to supercharge your road to financial freedom?  Get the book: SmallIvy Book of Investing: Book1: Investing to Grow Wealthy

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

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.