Stocks, mutual funds or exchange traded funds (ETFs): What is the best option when you want to invest in the stock market? Is it worth the time and risk to have single stocks in your portfolio, or should you instead select mutual funds or ETFs, which give you exposure to sectors you like without the risk of placing all your eggs in one basket?
While there are many factors to consider here—like the amount of time you have to dedicate to investing or your tax planning needs—there is one other theory in investing that comes into play. Modern portfolio theory focuses on maximizing your return without adding too much additional risk.
To summarize, modern portfolio theory says that there is a point where when you can combine different investments that will minimize risk for the entire portfolio while getting maximum returns. This occurs because when you combine assets, you are diversifying your unsystematic risk, or the risk related to one specific stock. You get this diversification because you buy stocks that have a low correlation to each other so that when one stock is up, the others are down.
With this risk diversification in mind, let's look at the pros and cons you should consider when deciding on whether individual stocks are right for you.
When Single Stocks Are Good
- When buying individual stocks, you see reduced fees. You no longer have to pay the fund company an annual management fee for investing your assets. Instead, you pay a fee when you buy the stock and one when you sell it. The rest of the time there are no additional costs. The longer you hold the stock, the lower your cost of ownership is. Since fees have a big impact on your return, this alone is a good reason to own individual stocks. (See also: Cost of Newly-Issued Stock.)
- It is easier to manage the taxes on your individual stocks. You are in charge of when you sell, so you control the timing of taking your gains or losses. When you invest in a mutual fund, the fund determines when to take the gains or losses and you are assigned your portion of gains. This is true even if you just bought into the fund at the end of the year.
- You understand what you own when you pick out the stock. You have complete control of what you are invested in, and when you make that investment.
The Downside of Single Stocks
- With individual stocks, it is harder to achieve diversification. Depending on what study you are looking at, you need to own between 20 and 100 stocks to achieve adequate diversification. Going back to portfolio theory, this means that you will have more risk with individual stocks unless you own quite a few stocks.
- Achieving this diversification is harder the less money you have. Especially when you start investing, you are subjecting yourself to more risk due to the lack of diversity. (See also: Investing for Safety and Income: Introduction.)
- When you own individual stocks, it requires more time from you to monitor your portfolio. You need to ensure that the companies you've invested in aren't having business problems that could wipe out your bet. You also need to monitor industry and economic trends. You're your own portfolio manager, so you must spend the time to ensure you're not holding a bad position.
- With individual stocks, you need to learn how to keep your emotions in check. It becomes easier to sell a loser or buy a hot-tip stock because you can instantly log in and make the trade in minutes. This can increase your fees for trading and can also lock in losses that would have been avoidable by holding something a bit longer.
The Bottom Line
When you are trying to get as much return as you can for the least amount of risk, your No. 1 concern should be diversification. While having low fees and managing your own tax situation is good, it is better to have adequate diversification in your portfolio. If you don't have the funds to make this happen, an ETF or mutual fund is probably better for you—at least until you build up a solid base of stocks. (See also: Top ETFs and What They Track.)