Why would a person choose a mutual fund over an individual stock?

Mutual Funds, Stocks
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These two strategies are not mutually exclusive and can compliment each other at the portfolio level. But there are many reasons for using funds with the main reason being easy, quick diversification with just one or two transactions. So, with just one trade, you can buy the entire S&P 500, the largest 500 companies in America, either using a conventional mutual fund or an exchange traded fund (ETF).  An ETF is my preference because it trades during the day like a stock rather than getting the net asset value, or NAV, at the close of the day.

With an individual stock, you have company specific risks known as unsystematic risk. This is the risk an individual company might get into trouble or possibly even going bankrupt. Having a plant blow up, an oil spill like the Exxon Valdeze or the BP Gulf Spill, food poisoning like Chipotle, accounting "irregularities" and a multitude of other things are examples of unsystematic risk. Even the CEO having an affair with his personal assistant could greatly affect the stock price, even though it really doesn't have anything to do with the fortunes of the company. Unfortunately, it is all about perception, especially with social media these days.

So if you are going to own just individual stocks, you need to have enough to invest in numerous companies to diversify away from company risks. If you have enough companies, you can diversify away from specific risk and just have systematic, or market risk. That is the risk of the overall market. Most studies show that if you own between 14-22 companies across different sectors in the S&P 500, you will track that index very closely with very little "tracking error." But now you have the increased cost of 15 or more trades. So, there is a tradeoff between tracking error and transaction costs.

With just 3 or 4 trades, you could own the S&P 500, the NASDAQ Index, and the Russell 2000 Small Cap Index. Thus, you could own a combination of mature, large companies, companies specializing in innovation biotech and technology, and the total broader market in small caps. In fact, there are even Total Market Index Funds where one trade can get you all of the above and you will have a mix of the total market.

Along that same methodology, if you believe a particular sector is going to benefit, but don't want to guess or figure out which individual stock is best, you can invest in a sector fund. For instance, a couple of months before the election, both candidates were talking about building out our infrastructure and we believed transports would benefit under either party. We took a position in the DowJones Transports Index using an ETF and it has worked out beautifully thus far.

If you used an individual stock, you could be right about your belief in a sector but dilute your strategy with an individual stock. The whole sector moves up with the exception of a couple of stocks, which may be yours.

The reason for using an individual stock is if you do lots of in-depth research and you like the story and prospects of that individual stock, you feel there is an opportunity that funds don't offer. You have the potential for larger returns, but that is coupled with more risks.

But let's take a look at combining the two at the portfolio management level. For instance, you use ETFs for say 60% of the portfolio and then 40% for individual stocks. The ETFs can be 10% for sector ETFs and 15% to 20% for broad index ETFs like the S&P 500. Then regarding stocks, no one individual stock can be more than 5%, so that you have 8 individual companies you believe to be the best of the best. These are your core holdings. If you then believe the market is getting more dangerous, you can raise 20% cash, therefore reducing volatility/risk by selling just one or two ETFs. If the markets continue to weaken, you can peal off another few positions so you have 40% cash while holding some key, core positions.

This is known a strategic versus tactical allocation. The strategic is a more long term buy and hold whereas the tactical is taking advantage of the current environment. This is active management, not passive however. Many advisors will just give you a pie chart based upon your station in life - age, risk tolerance, etc. I personally believe making money is more about the risks in the markets themselves and the market's time frame, not yours. You need to take both into consideration. I am just trying to get you to think beyond just one versus the other, because again, they are not mutually exclusive. Both mutual funds/ETFs and stocks are tools to get you where you want to go. Both have advantages and disadvantages.

But in summary, to answer the way you asked the question, the primary reasons for using funds or ETFs are lower costs and diversification. Funds need less ongoing attention and diligent research. Both are good strategies and we use a combination of both in concert. In fact, they compliment each other on a portfolio management level.

Hope this helps to stimulate your thought processes.  Happy Holidays, Dan Stewart CFA®

August 2016
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June 2005
August 2016