Saturday, May 30, 2009

Mutual Funds vs. Stocks: Better, Cheaper, Easier?

Fellow blogger Jenny Decki at BeyondMom asks the following questions:

Why would I invest in a mutual fund?

If I choose five stocks (or 10 or 15) isn’t that (basically) the same thing as being in a mutual fund but without the fees?

I understand that a mutual fund has a manager that watches the stocks within the fund and makes changes as appropriate, but how is that different than day trading? (Other than the fact it’s someone else doing the day trading.)


You raise some interesting questions: can you do what a mutual fund does and can you do it cheaply enough to make it worthwhile?

Mutual funds are still both cost effective, tax efficient, and in many cases, a far better investment than wading into the world of stock picking. Yes, mutual funds offer a fund manager(s), a level of research and discipline often not found in the individual investor, and the ability to diversify into a wide variety of stocks. Whereas the individual investor has far more flexibility to sell at moment's notice, some basic problems arise from the effort.

1. Which stocks to buy? While it depends on whom you listen to, the stock market has yet to retain any long-term stability. News, even reports that seem wholly irrelevant to the shares you might own, is still driving the investor to do things they would not normally do during a more stable and predictable market. True, no market offers itself to forecasts, and no stock is immune to industry trends, they can be and should offer some sort of confidence, a belief that the decision they have made is the right one long-term.

2. Which stocks offer long-term stability? Legendary investors always look for value. The average investor looks for gains. The two can be compatible but patience and time are what turns value into profits. Those looking for gains generally do not bring that sort of approach to the effort. Build a sample portfolio at any one of the financial portals and you can test this discipline before you commit real dollars. Keep in mind that these sample portfolios do not usually simulate trading charges or taxes.

3. Are stocks cheaper in the long run? Only in the long run. If you spend a fair amount of time looking at the tickers crawling across the bottom of broadcasts on CNBC for example, the wildly traded moves, the end of session strategies employed by many ETFs (exchange traded funds), and the instant reaction that many of these floor traders have to news (the ability to disseminate what is important right that minute to whatever position they may have taken) is very difficult for the average investor to control. Buying and selling all have costs (to you they are more expensive; to the institutional investor these costs are much lower) and depending on how much you have in your brokerage account, the advertised price many broker offer will be much higher.

4. Are stocks cheaper than mutual funds? Those same legendary investors offer the same legendary advice: fund your retirement, keep your financial house in order and only invest in individual stocks with money you do not need. Benjamin Graham, one of the most legendary of investors coined the term "Mad Money" to describe these accounts. He suggested that you should only put in money you do not need and never replenish those funds (if you win great; if you lose, lesson learned). Investing in stocks, for lack of a better analogy, is gambling. Ask yourself this: if you were at a casino and you had spent all of the cash in your pocket, would ask for a line of credit to continue?

That said, mutual funds still offer you the best way to keep your money working in the markets without taking outsized risks. Keep actively traded funds in your retirement account (the tax deferred opportunity is wasted on index funds in these types of accounts - keep them outside of your retirement account and pay the taxes on the gains and get the tax break on the losses). Be sure to take the time to build an adequate emergency account so you will never touch those retirement investments (these accounts are often referred to as savings - they are not), and if you still have money left over, wade into the ocean of stocks.

As Warren Buffet once said (as legendary an investor as you could quote):"price is what you pay; value is what you get."

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