Invest in Individual Stocks or Mutual Funds?
This is a guest article by Barbara Friedberg, editor-in-chief of Barbara Friedberg Personal Finance. Barbara holds an MBA in finance, a BS in economics, and an MS in counseling. In addition to writing, Barbara is a portfolio manager and a professor.
“The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.” — Warren Buffet
The greatest investor of this generation is espousing a fundamental investing maxim. Keep it simple and you will prosper. In fact, research shows that the more investing trades one makes, the worse their return.
How I went from funds to stocks — and back to funds
I started out terrified of investing in stocks either individually or in funds because of the crash in 1929. I thought that I would lose all my money if I invested in stocks of any form. That was before I had much investing knowledge.
History shows that stocks have outperformed bond and cash investments over the long term. Throughout the twentieth century stocks averaged 9.0%, with plenty of ups and downs along the way. Does that mean they will always perform that well? Absolutely not! In fact, the ten year return of the Vanguard Total Return Stock Index (VTSMX), effective July 27, 2010 is only an annual 0.05%. During that time period, cash and bond investments outperformed stock investments. That’s a far cry from the 9.0% per year average return.
After studying historical returns, I decided to invest in a stock mutual fund through my workplace retirement fund. I had 75% of my contribution allocated to a broad-based stock fund and 25% to a cash investment with a fixed return.
Over time, which do you think performed the best? If you guessed the stock fund, you were correct. But I was still happy to have the fixed return fund since it tempered my portfolio value when the stock market returns moved lower.
Buoyed by the performance of the stock fund and motivated by my passion for investing, I decided to investigate investing in individual stocks. I read every investing resource I could get my hands on and came across a non-profit organization designed to teach a fundamentally based stock research methods, the National Association of Investors Corporation. Their tools enabled me to research and analyze individual companies, look at their financial ratios, compare their valuation metrics and make a reasoned investment decision.
It was so much fun for me: the hours of reading annual reports, comparing return on equity, PE ratios, and more with similar companies. Of course graphing the metrics over time gave me a visual view of the direction of the companies’ sales and earnings.
During this period, I surpassed the benchmark returns by a couple of percentage points. I also earned an MBA in finance and got a job as a portfolio manager.
Investing in individual stocks is a lot of work!
Not only does the investor need to decide when to buy, but she must determine when to sell. That’s two opportunities to make a wrong decision. Furthermore, every investor has losses, and some of them are large. One of my worst stock losses was a decline of over 50%. Fortunately, I had the time and knowledge to devote to investing in individual stocks. I also had a temperament that is suited to remaining calm during the inevitable volatility of the investments.
Over the last few years, I have sold most of my individual stocks opting for a diversified portfolio of index funds.
Why I prefer fund investing to individual stock investing
The efficient market hypothesis supposes that in most cases it is difficult to beat the return of the overall stock market. There are many exceptions, but overall, holding a diversified portfolio of index funds or exchange traded funds is an efficient way to match the historical returns of the stock market. In fact, very few professional mutual fund managers beat the average stock market returns over time!
Advantages of investing in stock mutual funds over individual stocks
- Low cost
- Less research and maintenance time
- OUTPERFORM most actively managed funds
Invest in individual stocks if you:
- Enjoy the research and analysis necessary to choose individual holdings
- Have enough education to read a balance sheet and understand financial ratios
- Have sufficient time to devote
- Can tolerate the excess volatility above and beyond that of the overall market
Editor’s note: I (Flexo) invest mainly in stock mutual funds such as VTSMX but I occasionally dabble in individual stocks beyond my company stock purchase plan. I’ve lost money doing this — on paper, since I have not locked in any losses by selling. I still believe the companies I’ve invested in are good companies and will eventually see their stocks increase beyond my purchase price, and some have already. Do you invest in individual stocks or mutual funds?