The Case for Mutual Funds (and low-cost ETFs)

Do you own individual stocks?  Maybe you should, but maybe not.  It may depend on what type an investor you are.  You need to own stocks if you are a day trader since without stocks you are unlikely to have much if anything to trade.  This posting is not directed to day traders, but to investors who are interested in achieving longer term financial goals such as paying for children’s college, saving for retirement or buying a first home.  People in this category should not be day trading, but investing for the longer term.  I don’t consider day traders investors, but more like gamblers.

Long-term investors are folks likely to invest for at least five years or longer, consistent with the amount of time required for achieving their financial goals.  These people should not generally own individual stocks for the following reasons:

1.     They can never know as much about individual companies as do insiders (officers, directors, employees and consultants).

2.     Sound investing means being diversified and unless you own 20 to 25 different stocks you will not be well diversified.  Even then you run the risk of not being sufficiently diversified since companies change their business model, products and services from time to time.

3.     Owning individual stocks requires continuous research and tracking performance to know when to sell, or buy more.  This requires a substantial amount of time that most people will not devote unless they are professional investment advisors.

4.     Low cost no load mutual funds make diversification easier, can provide access to professional investment managers who do the research for you, track their holdings and often have access to companies’ management.

5.     Low cost index funds and ETFs (exchange traded funds) facilitate diversification at very low cost by replicating various market indices and segments.

I often hear, “Bill, I agree with your reasons, but are you telling me I should never own at least one stock”?  Not necessarily, but let me give you an example and some caveats.  We all are familiar with Apple and the Steve Jobs story.  During the last 12 months Apple stock reached a high of around $700 a share.  More recently Apple was trading at around $400.  That is a decline of more than 40 percent.  Many people were buying Apple on the way up or near the top, and now own a stock worth 40 percent less.  Worse yet, if they have to sell or have already sold Apple stock they will incur or already incurred a substantial loss.  I happen to believe that Apple is a terrific company, but no one likes seeing their investment decline by 40 percent.  My guess is that Apple was overvalued at $700 and probably undervalued at $400.  Investors who own Apple shares through mutual funds or ETFs are less susceptible to huge swings like this since other holdings in the fund tend to offset.

 Some caveats if you must invest in individual stocks are:

·       Maintain a separate pool of money that is not earmarked for any specific goal (think slush fund) for this purpose.

·       Do the research and monitor these holdings at least quarterly.

·       Do not try to time the market

·       Do not buy any stock you plan on holding less than one year since that is the holding period for taxing capital gains at the lower capital gains tax rate.

·       If someone tells you about a “hot” stock, wait until it cools off prior to buying it.

Feel free to add your comments to this posting.