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Welcome to Get Smart about Investing. After you make the decision to invest in the stock market with a portion of your portfolio and have an idea of how much money you want to place in large caps, small caps and international stocks, the next decision to make is whether it’s better to use individual stocks or stock mutual funds. This choice comes down to understanding the pros and cons of each method well enough to make the right decision. We’ll talk more about stock mutual funds later on. But first ask yourself how active a role you want to play in managing the stock portion of your portfolio.
Individual stocks tend to be a lot more work than using stock mutual funds. Look at all the factors you need to be concerned with: How much should you invest in technology versus healthcare? How much should you invest in each stock? When should you sell a stock? How should you keep track of all the different stocks? What overall strategy are you following? I often run into clients who invested in individual stocks and ended up with a portfolio that was too complicated to keep up with; not to mention the headaches these clients got when tax time rolled around. They had bad stocks that remained in their portfolio for years and good stocks they didn’t even know about. Individual stocks are great, but there can be a lot more upfront and ongoing work involved.
Most of the people I talk with who want to invest in the stock market usually have two or three ideas for individual stocks that they’re interested in, or came across a stock recommendation in the newspaper or on TV. In many of the cases, a better way for them to get started would have been to use a combination of both individual stocks and mutual funds. For example, if you were investing $20,000 in the large-cap portion of your portfolio, perhaps you could invest $12,000 in an S&P 500 index mutual fund and $8000 in individual stocks. Or you could put $4000 in each. This way, if your stocks are doing better than the S&P 500 index, you become one of the few people to outperform the market. But if those stocks aren’t doing do as well, at least a bulk of your money is well-diversified, allowing you to participate in the overall growth of the market over time.
How much money do you have to invest or is already invested in stocks? Do you have enough money to buy 10 to 20 different stocks from each of the asset classes: large caps, small caps and international? Getting good diversification with smaller dollar amounts is harder and more time consuming when you’re investing in individual stocks, and much easier to do with stock mutual funds. This is especially true for the small cap and international portions of your portfolio because most people are less familiar with these types of companies. For example, you would probably have an easier time understanding Coca Cola’s business model compared to a bank in India. Generally, investors who plan to use individual stocks should have at least $50,000 to $100,000 for their portfolios. Again, if you don’t have that much money to invest, use mutual funds for the bulk of your investment, then complement it with a few individual stocks.
Let’s say you had $60,000 to invest and wanted to put it in individual stocks. After some planning, you decided that you would allocate $30,000 to large caps and $15,000 to small caps and international stocks. Instead of investing all of the money in individual stocks, you can use mutual funds for the small cap and international portions of your portfolio, and individual stocks for the large-cap portion. That would enable you to focus your time on the area you’re more familiar with and use the expertise of mutual fund managers in these other areas.
How well have the stocks you’ve chosen performed in the past? Maybe you have the time and money to spend on enjoying the process of selecting individual stocks; but have you done it well? Can you tell me how your investments performed over the last year? Most people can’t. It’s challenging for anyone to separate the good stocks from the bad, year after year; not to mention someone who doesn’t do it on a full-time basis. For the average person, it’s difficult to implement a disciplined investment strategy for individual stocks. If it sounds like I’m trying to dissuade you from investing in individual stocks, it’s because I am. For most people I believe the convenience, professional management and diversification of a stock mutual fund outweighs its drawbacks and costs.
Most people I speak with say their financial lives are already too busy. They want to make good financial decisions but don’t want too active a role in managing their investments. The bulk of their portfolios should be in mutual funds, with occasional stock purchases, if they’re interested and have time for it. It makes sense to follow an investment plan that’s aligned with your interests and priorities.
I’m Greg McGraime and Now You Know!