A Financial Revolution 

December 21, 2005
Investing in Mutual Funds vs. Individual Stocks

Mutual funds are big business! E*Trade offers almost 6,000 different funds to its customers, Ameritrade more than 11,000. This leads to a logical question: with so many mutual funds to choose from, am I better off with a mutual fund or a portfolio of individual stocks? Unfortunately, there is no easy answer to that question. The answer will depend on a number of factors, including:

  • Time Commitment: It takes time to research stocks and build a well-diversified portfolio. If you buy a mutual fund, you are paying the fund managers to do the work for you.
  • Funds Available: Most mutual funds can be purchased with a small nest egg - about $1,000. Even with a brokerage like ShareBuilder ($4 commissions), it would be difficult and expensive to build a portfolio for $1,000.
  • Moral Convictions: There are a growing number of boutique funds that cater to different beliefs, including religion, environmental protection, and/or labor relations. In general, however, funds are still very broad and may hold investments that you don't want to own.

Let's start by exploring some of the benefits of owning mutual funds:

  • Mutual funds offer greater diversification than the average investor can manage. Most mutual funds own fifty or more different securities. This helps reduce the risk of loss because the portfolio is not dependent on the performance of one to ten stocks. On the other hand, this level of diversification also reduces the opportunity for big gains (see the first benefit under stocks.)
  • Funds provide a cheap and easy method for reinvesting dividends. Note that some brokerages offer free dividend reinvestment plans for individual stocks.
  • When you buy a fund you are hiring a professional to manage your money. That professional is (presumably) monitoring the economy and the markets to adjust the fund's holdings appropriately.

Now let's explore some of the benefits of owning individual stocks:

  • Stocks offer more potential profit (and loss). It's essentially the opposite of the diversification issue: If you own just one stock and it doubles, you are up 100%. If a mutual fund owns 50 stocks equally and one doubles, it is up 2%.
  • Stocks don't charge a management fee every year. Mutual funds often charge between 1% and 3% per year and some even have a purchase fee (load).
  • You can buy and sell when you want and manage your tax liability. Mutual funds may sell shares throughout the year and you pay taxes on the capital gains whether you see the cash distribution or not.
  • You can write options on your stocks.
  • You can structure your portfolio differently from any existing mutual fund portfolio.
  • You can buy smaller cap stocks which aren't suitable for mutual funds to invest in (including going private transactions.)

In the end, the answer is probably not one or the other. Most investors may find it useful to own both mutual funds and individual stocks. For example, I own bond funds because I don't want to buy and manage individual bonds. For stocks outside of my 401k, I built my own portfolio.

My advice: If you're starting out and have a small amount of money to invest, buy a good Index fund. As you build up more money, if you have the time and interest, invest those funds in individual stocks. You could also consider some of the excellent dividend reinvestment plans, or DRIPs, available directly through companies (see The Power of a DRIP.) These programs often require small initial investments and your dividends are automatically reinvested.

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