Mutual Funds Probably Better Option Than Individual Stocks

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Mutual funds are a better option than individual stocks for most investors.  The decision to invest in mutual funds or individual stocks depends on the size of your portfolio, your investment knowledge, your level of time and involvement, your risk tolerance, your ability to make objective investment decisions and your tax situation.

Many investors don’t have enough money to adequately diversify their portfolio across a wide range of individual stocks.   To gain true stock diversification, you need to invest in companies of different sizes, in a wide range of different industry sectors and in a variety of different geographies. Mutual funds enable you to gain this broad diversification by pooling your money with a large number of other investors.

Additionally, mutual funds are professionally managed, making them ideal for individuals with limited investment knowledge or a limited amount of time to research and monitor individual stocks.  Most mutual fund companies have a large staff of managers and research analysts who analyze financial reports, visit companies and keep tabs on the economic and political climate.  It is very difficult for most     investors to devote the time and commitment needed to create and maintain a well-diversified portfolio of individual stocks.

Professional managers also have access to more timely information.  Many investors are tempted to buy and sell individual stock based on current events.  However, the market is relatively efficient which means it quickly responds to new information.  What seems like breaking news has probably already been factored into the price of the stock.

Unfortunately, diversification and professional management does not come without a cost.  Most mutual funds charge an annual management fee of between .25 and 1.25%.

Additionally, when investing your own money it is hard to stay objective.  We have a natural inclination to emotionally react to changes in the market and to become emotionally attached to specific stocks.  It is easier for mutual fund managers to make objective decisions.  Performance is usually better when we stay on course and history shows us that investors in individual stocks trade more frequently than mutual fund investors.

Mutual funds can also be a better option for investors who are risk adverse. By investing in a broadly diversified portfolio of mutual funds, most of your risk will come from fluctuations in the market.  A portfolio comprised of several individual stocks is generally more volatile.  It also carries a higher risk of losing money if a company, whose stock you own, has financial problems or goes out of business.

A disadvantage to owning mutual funds, instead of individual stocks can be a lack of control on when you pay capital gains. This is especially true if you are in a high tax bracket and a lot of your money is invested outside of retirement accounts.  When fund managers sell stock, gains must flow through to the investors as they are earned, not when the fund is sole.

Asset Allocation – the Foundation of Your Portfolio

Jane Young, CFP, EA

Jane Young, CFP, EA

Your asset allocation serves as a foundation from which to build your investment portfolio.  An asset allocation identifies the types of investments and the proportion of each you plan to hold in your portfolio.  At a very general level most investments are broken into three categories: stocks, interest earning, and real estate.  Each of these broad categories can be broken down further into hundreds of different options.   The two factors that usually drive an asset allocation are the timeframe in which you will need your money and your personal risk tolerance.  Generally, we strive for a diversified portfolio that provides the highest rate of return for the level of risk we are willing to take.

The first step in developing an asset allocation is to evaluate your current situation and determine when the money you are investing will be used.  Money that is needed in the short term should be placed in interest earning investments, not in real estate or the stock market.  Interest earning investments, such as money market accounts and CDs, are secure but usually provide a rate of return below the rate of inflation.  While it’s important to keep your short term money safe, too much in interest earning investments will stifle the long term growth potential of your portfolio.

Once your short term money has been secured, you can create a diversified portfolio that supports your investment timeframe and risk tolerance.   A great way to diversify is through the use of low cost mutual funds.  Mutual funds enable groups of individuals to pool their money to buy a large number of different companies or government entities.  Mutual funds enable you to maintain a diversified asset allocation by investing in funds with different objectives.  Consider selecting funds that invest in a variety of stocks and bonds in large, medium, and small companies within different industries and different geographical regions.  Your goal is to maintain diversification so that when one category is doing poorly it may be offset by another category that is performing well.   A diversified asset allocation allows you to spread out your risk so you don’t have dramatic losses if a given company or asset class performs poorly.   Additionally, by spreading your asset allocation over a broad range of investments, you may have opportunities that would have been too risky in an undiversified portfolio.

Your asset allocation is the framework of your portfolio – establish a plan that meets your objectives and stick with it!  Avoid making changes to your asset allocation based on emotional reactions to short term changes in the market.   Over time, your portfolio will get out of balance due to fluctuations in the market.   I recommend adjusting your portfolio by rebalancing on an annual basis.  In addition to keeping your asset allocation on target, the need for rebalancing will result in selling stock when it is high and buying when it is low.

Stock Market Investing Requires a Long Term Perspective

 

Jane Young, CFP, EA

Jane Young, CFP, EA

The recent volatility in the market has prompted some investors to question the future direction of the stock market.  Unfortunately, the stock market is impacted by so many factors that it is impossible to predict short term movements.  Over the long term, the stock market has always trended upwards but the path has been anything but smooth.   We could be on the tipping point before a major correction or at the beginning of a long bull market – we just don’t know. 

As a result of this uncertainty, it is impossible to effectively time the market.  Not only do you need to accurately predict when to sell but you also need to know when to re-enter the market.  Even if you select the right time to sell, there is a good chance you will be out of the market when it makes its next big move.  

To compound this issue, decisions to buy and sell are frequently driven by short term emotional reactions.   The fear of losing money can trigger us to make a sudden decision to sell, or the fear of missing an opportunity can cause a knee jerk reaction to buy.  We need to resist these very normal emotional reactions and maintain a long term focus.  The stock market should only be used for long term investing.  If you don’t need your money for at least five to ten years you are more likely to stay invested and ride out fluctuations in the market. 

If you lose your long term perspective, and react to short term emotional reactions, you can get caught up in a very detrimental cycle of buying high and selling low.  An example of a common cycle of market emotions begins when the market drops and you start getting nervous.   Over time you become increasingly fearful of losing money and end up selling your stock investments after the market has dropped considerably.   Then you sit on the sidelines for a while, waiting for the market to stabilize.  The market starts to rebound and you decide to jump back in after that market has gone back up.  Afraid of missing a great opportunity, you buy at the market peak.   This is a self-perpetuating cycle that can be very harmful to your long term investment returns.

To avoid the temptation to time the market and react to emotional triggers, keep a long term perspective.   Focus on what you can control.  Maintain a well-diversified portfolio that is in line with your long term goals and your investment risk tolerance.  Live within your means and maintain an emergency fund of at least four months of expenses.  Invest money that you will need in the short term into safer interest earning investments.   By limiting your stock market investments to long term money, you will be more likely to stay the course and meet your investment goals.

Investing in a Volatile Market

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Here are some things you should keep in mind when investing in the stock market; the market will fluctuate, there will be years with negative returns, the stock market is for long term investing, and the media and prognosticators will greatly exaggerate negative information to create news and get attention.  If you keep this in mind, you can dramatically improve your long term investment returns and sleep better at night.  Based on numerous studies conducted by DALBAR, the average investor earns several percentage points below the market average due to market timing and emotional reactions to market fluctuations.  It’s how we are wired.  When the market goes up, we feel good and we want don’t want to miss out on the opportunity to make money.  As a result, we buy stock when the market is at its peak.  On the flip side, when the market drops we worry about losing money, and sell when the market is at the bottom.  It’s hard to make money in this cycle of buying high and selling low.  When investing in the stock market, try to avoid overreacting to the inevitable short term fluctuations in the market.

Other factors that can help you ride out dramatic fluctuations in the market include establishing a solid financial foundation and maintaining an asset allocation that meets your investment timeframe.  Establish a solid financial foundation by living within your means, minimizing the use of credit, and maintaining an emergency fund of 3 to 6 months of expenses.  A strong foundation helps you avoid pulling money out of the stock market at inopportune times should an emergency arise. 

Once you have established a strong financial foundation you can start investing in the stock market.  One key to success with stock market investing is establishing an asset allocation that’s in line with the timeframe in which you will need money.  Money that is needed in the short term should not be invested it the stock market.  As a general rule, do not invest any money needed within the next five years in the stock market.  Over long periods of time the stock market has trended upward, but in the short term there have been periods with substantial drops.  Give yourself time to ride out the natural fluctuations in the market.  

Additionally, it is important to diversify your money across a wide variety of investments.  You can reduce the amount of risk you take by diversifying across different companies, municipalities, industries, and countries.  When one type of investment is doing poorly, another may be doing well.  This helps to buffer the losses you may experience in your portfolio.  An excellent way to diversify is through the use of a variety of different types of mutual funds.  Mutual funds pool your money with money from others to invest in a large number of companies or government entities based on a predefined investment objective.

1 2 3 4 5 12