A Financial Revolution 

March 03, 2006
Why You Can Beat the Market & Mutual Funds Seldom Do
There is a continual debate among bloggers and personal finance sites asking whether it's better to hold individual stocks or trust mutual fund managers with our money (see funds vs. stocks.) Often, those recommending mutual funds argue that funds have experienced money managers, proprietary research, and access to company insiders - things many of us lack - so it would be foolish to think that we could do better by investing in individual stocks.

While it's true that funds have more resources and greater access to information, they also are faced with a huge challenge: too much money! The average large-cap mutual fund has more than $1 billion in assets. If the manager of one of these funds wants to create a portfolio consisting of their 10 best stock ideas, they would have to invest more than $100 million in each company. Since the manager won't want to own more than 10 percent of a company's outstanding shares (for both legal and liquidity reasons), that means only companies with market caps of $1 billion or more - less than 10% of the market - are potential investments. If the manager expands their search to companies with lower market caps, the manager must hold even more stocks.

When the manager is picking stock number 20, 30, 50, or 200, they are purchasing the investment because of the dollar size of the portfolio, not because the last picks are as good as the first or because they are necessary for diversification. So, mutual fund managers must find more good stock ideas from a smaller universe of investments and buy and sell large volumes without influencing the share price. When you tack on administrative fees, it's no wonder that most mutual funds underperform the market or become stealth index funds.

Fortunately, as individual investors, we don't face those same constraints. For people without the time or interest to research stocks, mutual funds can be a good alternative (particularly low-cost, no-load index funds.) For others, creating a portfolio of their six to ten "best ideas," perhaps with some portion of the portfolio in an index mutual fund or exchange-traded fund, will create opportunities to beat the market over the long run.

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Anonymous The Dividend Guy said...

Good post...too many people just assume it is easier to pick an ETF over individual stocks. Maybe it is. For me there is a great deal of fun in selecting individual stocks and using a fund of ETF just doesn't cut it. So far it has worked for me.

3/04/2006 7:18 PM  

Anonymous personal finance advice said...

The Carnival of Investing is live. Thank you for your contribution!

3/06/2006 12:00 PM  

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5/20/2006 5:20 AM  

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