Have You Outgrown Your Mutual Funds?

When it comes to investing, many of us stick to mutual funds. After all, they’re generally the only option in employer retirement plans (except perhaps for company stock) and financial advisers like to sell funds because they’re relatively easy for them to manage. They also make a lot of sense when you’re just starting out with investing and don’t have enough to purchase in individual securities. However, as your portfolio grows, you may want to consider purchasing individual securities, especially if your portfolio is taxable. Here are some reasons why:

1)      Mutual funds may be more expensive. First, there are sales loads that you may have to pay if you buy your fund through a  broker. Second, there’s the annual expenses that the fund charges for management and marketing. Finally, there are also hidden trading costs. Just like when you buy an individual stock, the fund has to pay trading commissions. But in addition, when a fund buys a stock, it can push the price of that stock up, forcing the fund to buy at a higher price. When the fund sells, it can push the price down, forcing the fund to sell at a lower price. In this case, bulk purchasing actually works against you. Since these costs can add up to 3% of the fund’s value, they cost you more the more money you have invested in them. Instead, you can use investment newsletters like Value Line to get advice and recommendations on individual stocks for a fixed and relatively low cost and purchase them for less than $10 a trade on online discount brokers like Charles Schwab, Fidelity, TD Ameritrade, Scottrade, and E-Trade. You can also learn more about picking individual stocks from resources like the American Association of Individual Investors.

2)      Mutual funds can be too diversified. If a fund only bought the stocks that the manager wanted to buy, it could cause the fund to own too much of some of the stocks. In fact, a large fund could end up buying entire small companies. To avoid this, mutual funds have to add lots of other stocks that the manager may not even want to buy. Pretty soon, your fund can end up owning practically the entire stock market like an index fund but with a much higher price tag. Alternatively, you can be diversified with as little as 20-30 individual stocks from different sectors of the market and limit them to the ones you believe in the most, either for investment or ethical reasons.

3)      Mutual funds can generate a lot of taxes. That’s because you can end up owing taxes on capital gains whenever your fund buys and sells. You can even pay taxes on someone else’s gains from before you ever bought the fund. With individual stocks, you only pay capital gains taxes when you decide to sell them and only on your gain. There are also more opportunities for reducing your taxes through tax loss selling and gifting appreciated shares.

4)      Individual stocks provide more trading flexibility. You can buy and sell them throughout the trading day, write options on them, sell them short, and buy them on margin. While many of these tactics can increase risk, you can also limit your risk with a “stop-loss order,” which automatically sells your stock if it falls in price by a certain amount. In contrast, mutual funds can only be sold when the market closes.

5)      Bond funds aren’t really “fixed” income. Both the income and the value of bond funds can fluctuate quite a bit. If you own an individual bond, you can lock in an interest rate and get the face value of the bond when it matures no matter how much the value fluctuates in the meantime. Of course, this assumes that the bond issuer doesn’t default and that you don’t need your money before it matures.

That being said, there are also some reasons to stick to mutual funds. For one thing, they may be your only option if you’re only investing in your 401(k) or if you’re just starting out and don’t have enough money to diversify in a cost-efficient manner. (Even a $7 commission can add up to a large percentage of your investment if you’re buying 20 stocks with only $500.) You may also not have the time or interest to research and pick your own stocks and hiring someone else to do that may be more expensive than a mutual fund.  Finally, you may have a fund manager that you really believe in and think is worth the cost. In any case, make sure you’re making a decision based on your specific needs and wants rather than just because it’s how you’ve always done it.

 

 

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