Financial Advice for My Son


Mutual Funds and Individual Stocks

Mutual Funds versus Direct Stock Ownership

Unless you have at least $30,000 to invest in stocks, you should not invest directly in stocks. Instead, you should use mutual funds to own stocks. The reasons are simple:

- To be adequately diversified, you must own at least 10 stocks. Owning fewer stocks subjects you to additional risks for which you are not compensated by additional return, since there is no "need" to assume that additional risk. (The additional risk is that something specific might affect those stocks or industries. For example, the chairman of the company might die, a Bhopal or Three Mile Island disaster might strike, or technology might make your Buggy Whip company obsolete.) Studies have shown that with 10 or more stocks, you have essentially achieved the average market risk.

Ownership of only 1 stock gives you a standard deviation which is three times higher than that of the market! Thus if you only buy 1 stock, you are taking three times the risk inherent in a diversified portfolio. You won't be compensated for that risk with a higher return because there is no need to assume that risk since it can be diversified away.

- In order to minimize trading commissions, you must buy a "round lot" of 100 shares. With an average share price of $30, that totals $3,000 per stock. With a minimum of 10 stocks to invest in, the grand total is $30,000 in order to do it.

If you have more than $30,000 to invest in stocks, you should definitely own stock directly instead of through a mutual fund. The reasons:

- As a small investor, you can take advantage of opportunities that a giant mutual fund cannot. For example, you can put a significant portion of your stock assets in small companies. Most mutual funds cannot place a significant portion of their assets in small companies because the total market value of small companies is less than the size of some mutual funds! Furthermore, if they tried to place a significant investment in small companies they would perturb the market so much that they would get a poor price. In fact, the "small company effect", the increased return from small companies, is at least partly due to the fact that as soon as a small company reaches a certain size, it becomes possible for institutions to own their stock, and therefore their price goes up due to increased demand.

- You can pick companies at least as well, and probably better, than the managers of most mutual funds. (For example, the manager of giant Fidelity Magellan, Peter Lynch, boldly makes this claim!)

- Mutual funds have high expenses, due primarily to high portfolio turnover rates, that you won't face if you are a smart long-term investor.

- With direct stock ownership, you can control when you take capital gains. In effect, you can defer taxes significantly in this way, whereas mutual funds must distribute all their capital gains each year, which are large due to high portfolio turnover rates.

Therefore, once you have build up $30,000 in mutual funds, you should begin to buy individual stocks. At the beginning, it is OK to buy just one stock because you are still diversified by virtue of having most of your money in a mutual fund. Merely limit yourself to investing no more than one-tenth of your money from the mutual fund in any one stock. It is OK to buy all ten of these stocks at once with your money in the mutual fund because you are merely transferring money from one set of stocks to another, so the Ease In and Ease Out rule doesn't apply. You can continue to apply that rule by maintaining your monthly investment in the mutual fund and using the money in the fund to buy individual stocks whenever you have selected any.

I give no advice here on picking stocks. That is in the advanced course, currently self-taught!

Mutual Fund Selection

How do you pick a mutual fund? The answer is quite easy. The rules:

- Never pick a fund that has a sales charge, called a load, or one with a "continuous load" called a 12b-1 charge. These charges are now detailed in the beginning of the prospectus that you must receive in order to invest in any fund. All studies have shown that there is no performance difference between a fund that charges a load and a "no-load" fund. A load is purely an incentive for someone to sell you that particular fund. It is a sales fee that goes purely, wholly, entirely, to the salesman. None of that load goes toward buying expertise in picking stocks, etc. It is a tribute to the stupidity of the average investor that 80% of all investments in mutual funds last year were placed in load funds!

- (Almost) never pick a fund that is at the top of any short-term (less than 5 years or so) ranking of mutual fund performance. In general, the top-performing mutual funds in such lists are poorly diversified sector funds that are much more risky than stocks in general. Think about it. If you have a very volatile fund, it is guaranteed that there will be periods when the fund has a very good return and it will therefore make the top ten list. It is also guaranteed that these funds will make the bottom ten list, usually soon after they have made the top ten list and have attracted a lot of investors!

- Pick a fund that has a very low expense ratio and very low portfolio turnover rate. Because mutual funds essentially make up "the market", and there is no evidence around that anyone can significantly beat the market, the average return from the stocks in mutual fund portfolios matches the average return of the market. However, mutual funds must pay trading costs, since most of them pursue an active trading philosophy, which even for them is several percent per round-trip (buying and selling a given stock). In addition, they must pay for the operations of the fund, including investor services and advisory fees for the "wonderful" advice that they are getting. Both of these costs cause the average mutual fund to significantly underperform the market by several percent per year. (In a given year, only 25% of all mutual funds beat the market, consistent with what chance would predict. 75% of all mutual funds underperform the market. Over longer time periods, almost no mutual funds beat the market. The number of those that do beat the market is again consistent with chance!)

- Pick a fund that matches your investment goals. There are funds that use leverage (borrowing) in order to be riskier than the average of the stock market, which guarantees that they will do better than the market if it goes up, but worse than the market if it goes down. (If you know the market is going up, these are the funds to be in!) There are very conservative funds that invest in less risky stocks, which guarantees that they will do worse than the market if it goes up, but better than the market if it goes down. There are "sector funds", which are very poorly diversified on purpose, which bet that "technology stocks" or "gold stocks", etc., will outperform the market.

In fact, there are now more mutual funds available than there are stocks!

- Many large pension funds and smart individuals have recognized by now that it is extremely tough to beat the market. Therefore, the concept of an "index fund" which simply tries to match the performance of some stock index, have become quite popular. An index fund has very low expenses, because they do not pay an advisory fee and minimize portfolio turnover with its resulting trading costs. Vanguard pioneered this concept with its Index 500 fund, which attempts to match the S&P 500 index, which simply owns a piece of every one of the top 500 corporations in America, weighted by the value of the company. Its expenses average 0.4% of assets per year, as opposed to the average mutual fund with expenses over 1% of assets per year.

Penny stocks

Never, ever, ever, buy "penny stocks" (any stock selling for less than $1 per share). These stocks are eternally the objects for fraud, with market manipulation abounding. In addition, the bid-ask spreads (price you pay to buy versus price you pay to sell) that can approach 100%!

Go To:
Previous Page (Investing - Other Tidbits)
Next Page (Investing - Bonds)
Table of Contents

Go To:
Tom's homepage

e-mail: Tom Chester