Time to Dump Your Mutual Funds?

May 01, 2014

No, I’m not talking about “sell in May and go away.” If you invest in stocks, you probably do so through mutual funds. After all, they’re available in your employer’s retirement plan and you get a degree of instant diversification even if you don’t have much to invest. But here are some reasons you might want to consider investing directly in individual stocks:

1) You can avoid mutual fund costs. It’s been well-documented that the vast majority of mutual funds underperform the market and one of the main reasons for that are the various fees and trading costs they incur. By buying stocks directly, you can avoid the mutual fund fees and by not trading often, you can minimize your trading costs. The larger your portfolio, the more you can save.

2) You can focus on only your best stock ideas. Another reason that mutual funds have trouble outperforming the market is that their sheer size typically forces them to buy many more stocks than the ones they might like. While this makes them more diversified, many experts argue that you get virtually all the benefits of diversification with just 20-30 individual stocks across a range of sectors. Instead, a lot of funds end up owning practically the entire stock market and become expensive closet index funds.

3) You can invest in stocks that are too small for mutual funds. Historically, small cap stocks have had the highest returns of all the categories of stocks but the smallest and most profitable are too small for mutual funds to invest in. This lack of involvement by professional money managers may also make this area of the market more inefficient, which means more opportunity for the individual investor to find opportunities that haven’t been exploited by the professionals. Just be aware that these microcap stocks tend to come with more risk so be sure you’re diversified.

4) You have more control. With a mutual fund, you have no control over what stocks you ultimately own. If you don’t like the holdings, your only option is to sell the fund. With individual stocks, you maintain full control and can avoid stocks that don’t fit your investment criteria or moral values. You can also sell shares of stock during the trading day and use options and stock loss orders to avoid large losses.

5) You have more opportunities to minimize taxes. If you have mutual funds in a taxable account, you may have discovered that you have to pay capital gains taxes even if you haven’t sold the fund and even if the fund has actually lost money. With individual stocks, you can hold them indefinitely and gift them or eventually pass them on to your heirs without any capital gains taxes. Since they tend to be more volatile than funds, there are also more opportunities to sell losses and write them off your taxes.

Of course, there is a downside to investing in individual stocks. They take more time to research, purchase, and manage. Next week, I’ll review some web sites that can help you make that easier.