Are Mutual Funds Always a Better Choice Than Individual Stocks?
Over the past few decades, mutual funds, along with their newer cousin, exchange-traded funds (“ETFs”), have ballooned in popularity. These financial tools provide convenience: you can diversify your investments in one fell swoop, so you are less subject to loss if any one company fails.
Mutual funds can also help you buy an entire index or industry group quickly and easily instead of picking individual stocks.
People often assume that investing in mutual funds is inherently safe and will save them money. Many are surprised to find out that neither of these statements is necessarily true.
Instead, there are always pros, cons, and risks in every investment, including mutual funds. While these funds do bring convenience, there’s a cost for that as well as other ramifications you may not have anticipated (like tax impacts). All of these issues can potentially reduce your returns, sometimes dramatically.
That’s why it is critically important that you understand both the benefits and the costs of the investments you own.
Mutual Fund Dirty Little Secrets
So what is the difference between investing in mutual funds or investing in individual stocks? Let’s take a look.
Mutual funds are not easy to understand. Few people take the time to read the long, fine-print-laden “prospectus,” which is the document that mutual fund companies must provide to investors. Instead, with trillions of dollars at stake, the industry spends millions on advertising to get you to focus on what they want you to see. But here are some things you need to know that you probably won’t see in the ads.
With individual stocks, you have control of your tax liability. You (or your wealth manager) decide when to sell, so you can control when you recognize a gain or loss for tax purposes. If you’re faced with a gain, strategies such as tax-loss harvesting can help you lower your tax bill. This is something that we carefully manage for our clients at our firm. Why? Because every dollar you pay in taxes comes out of your bottom line. If we can save you taxes with investing, that’s one more dollar that stays in your pocket.
When it comes to mutual funds, you lose most of that control. Mutual funds are a commingled investment, so they are managed for the benefit of all shareholders. You don’t get any input on the timing of taxable events. Instead, you get a tax bill for gains the manager decided to take. Unfortunately, that can even mean that you sometimes pay taxes on gains you never received in the first place. That’s very different than with individual stocks, where you only pay tax if you realized a profit.
There’s a term for this problem: tax inefficiency. How much does tax inefficiency cost a mutual fund investor? Researchers at Morningstar, Inc., a mutual fund research firm, estimate you lose about 1.10% per year.
Investment Fees and Expenses
Like taxes, investment fees and expenses are a direct cost to you. They eat into your bottom line, so you need to keep an eye on them. With individual stock portfolios, commissions and trade expenses are very low. Then, you’re probably paying your financial advisor to manage your portfolio, so that is a cost. Generally, as your portfolio grows, that fee usually drops on a percentage basis.
However, if you buy a mutual fund, you’ve suddenly introduced another layer of management to your team. If you also have a financial advisor, that means you are paying two sets of management fees.
If you’re just starting, that may be unavoidable, but mutual funds may not be the optimum investment tool for you as your assets grow.
Taxation and costs are two significant areas of concern with mutual funds. Here are a few others.
It is critical to know exactly what you are paying in fees and costs to measure your net return on your investments.
With individual stocks, that information is typically easy to find. Trading costs are usually itemized on your account statements. Then, your financial advisor fees will be disclosed to you upfront in writing in an investment management agreement, and these fees are typically billed to you quarterly. So they are usually easy to identify and monitor.
Mutual funds are a very different matter. As a consumer, it can require some detective work to figure out precisely what you are paying since there can be many different layers of fees and costs. You can expect to pay a management fee, trading costs, loads, redemption fees, operating expenses, and possibly marketing and sales costs. Unlike stocks, these costs are not usually itemized on your fund statements. You must research these yourself. As you probably can imagine, few people take the time to do so.
Individual stock portfolios can be designed specifically for your needs. That means that each investment is added to achieve your goals and help manage your risk. With mutual funds, that’s not the case since the fund is managed for many shareholders. So your individual needs are not considered.
One thing mutual funds do offer is fast and easy diversification. Strangely though, this diversification can sometimes work against you. Today, many mutual funds have become over-diversified, so much that they can limit the ability to generate returns for you.
With individual stocks, your portfolio can be as concentrated or diversified as it needs to be to achieve your goals with the least amount of risk. At Partnership Wealth Management, our philosophy is that you need a certain amount of concentration to produce meaningful investment results. And that in many cases, diversification is overdone and works against you on the upside while retaining the majority of downside risk when markets drop.
Are Mutual Funds Ever The Right Choice?
As you can see, there are costs to mutual funds that many people don’t even consider. These aren’t mentioned in the media much, as the industry has downplayed many of these drawbacks quite well. But the costs are real.
However, in some situations, mutual funds can provide you a strategic advantage. The key is to use them judiciously when the benefit outweighs the cost.
Another factor is that recently, the cost of maintaining an individual stock portfolio has dropped dramatically. But not all financial firms have caught up.
Your money is critical, so if you’re invested in all mutual funds with your financial advisor, speak up and ask why. The strategy may be sound and well suited for your needs. But it’s your future, so be sure to ask questions and get a second opinion if you’re not sure you are getting the best service possible.
At Partnership Wealth, we use mutual funds when appropriate. The critical factor is that, together with our client, we determine what is most likely to work best. Overall, our goal is always to help you achieve your goals with the least amount of risk.
Questions and Consultations
If you have questions or if you’d like to schedule an appointment to discuss your finances, contact us today.
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The opinions voiced in this material are for informational purposes only and are not intended to provide specific advice to any individual. Consult your legal, tax, and/or financial advisor to determine what is appropriate for your situation.
As a Registered Investment Advisor (RIA), Partnership Wealth Management is committed to providing our clients with financial planning and wealth management services to help them work towards their financial goals. At Partnership Wealth Management, we have a long history of working with the LGBT community. Among the many services we offer are financial planning and estate planning strategies for gay and lesbian couples. Financial planning is an important part of preparing for the future; contact us today to get started: www.partnershipwm.com.