Getting Going / By Jonathan Clements
( WSJ, 12-29-98 )
Stock Mutual Funds Are Still a Good Bet
Most stock mutual funds are thoroughly mediocre. But
they are still better than the alternative.
Lately, it has become popular to trash mutual funds. More
and more, I hear investors dismissing mutual funds as a
starter investment and saying they plan to graduate to indi
vidual stocks. Similarly, financial planners, eager to offer
their clients the aura of exclusivity, have begun eschewing
funds in favor of private money managers.
This backlash isn't surprising. Too many stock funds
charge too much, return too little and pay scant attention to
taxes. Nevertheless, mutual funds remain the best bet for
most investors. Here's why:
LESS STRESS:
Experts tell us to put together a diversi
fied collection of investments and then focus on the entire
portfolio. The reality, however, is that investors
tend to fret about their poor performing
investments, even if the rest of their
portfolio is doing just fine.
By dumping stock funds and
buying individual stocks, you take
this stressful situation and make
it worse. After all, individual
stocks perform far more erratically than funds. In addition,
you will probably end up with a
larger number of separate investments, which means you
will have more potential causes
for concern.
LOWER RISK:
The fewer
stocks you own, the greater the
chance that your portfolio will be
torpedoed by one or two rotten
stocks. That is a real danger for
those who stick solely with individual stocks.
It isn't, however, a problem
for stock fund investors. Many
funds own between 30 and 300
stocks. And many investors own three funds, four funds, or
even more. These investors might have exposure to as many
as 1,000 stocks. Given that diversification, it is unlikely that
any one stock will cause severe damage.
KEEPING UP:
Most years, the return of the Standard &
Poor's 500 stock Index is skewed upward by a minority of
stocks that post explosive gains. Meanwhile, most of the index's constituent companies lag behind the average. If you
don't own some of the stellar performers, your results will
badly trail the S&P 500.
That is a distinct possibility if you avoid funds and buy individual stocks. Let's say you usually buy 100 shares of any one
company, and the typical stock price is $50. Even if you have
$100,000, you will be able to buy only 20 stocks. With that thin
spread of companies, you may end up with little or no exposure
to the winning stocks that are driving the S&P 500's gains.
STEEPING OUT:
Of course, there is a lot more to the market than the S&P 500, an index of blue chip stocks. What if you want to diversify into small companies and foreign shares, as many experts advise? For all but the wealthiest investors, funds are the onIy sensible choice.
COMPARE AND CONTRAST:
You can easily find out how your funds have performed. All you have to do is look in the newspaper or read your fund's latest shareholder report. There, you will probably find returns that reflect the impact of annual fund expenses and, sometimes, fund sales commissions as well.
But figuring out how your individual stocks have fared is far trickier. Sure, we all remember the big winners. But what about the losers? What about dividends? What about the brokerage commissions and other trading costs we incurred? What about the extra risk we shouldered in buying individual stocks?
Unfortunately, most folks don't really know how their
individual stocks have done, so they can't honestly judge whether they are better at picking stocks or picking funds.
TAXING MATTERS:
If you own individual stocks, you have far greater control over your annual tax bill, because you can delay capital gains taxes by postponing the sale of profitable positions. By contrast, most actively managed stock funds trade like crazy and, hence, generate big tax bills for their shareholders.
But that doesn't mean high tax bills are unavoidable for fund investors. You could stick these high trading funds in your retirement account, while being much more selective about what you hold in your taxable account.
For instance, many fund companies have introduced tax managed funds, which aim to keep taxable distributions to
a minimum and, thus, are a good choice for taxable accounts. Also consider index funds. These funds simply buy and hold the stocks that constitute a market index in an effort to match the index's performance, so they tend to be tax friendly.
ANYTHING BUT AVERAGE: The typical stock fund is a fine choice for investors, despite its tax inefficiency, high cost and indifferent performance.
But then again, who says you have to buy the typical fund? It is so easy to do better. It takes no great effort to stick with funds that are no-load and low cost, preferably with annual expenses below 1%. And it is simple to arrange your finances so that you keep tax inefficient funds in your retirement account.
What about the lackluster results? That problem, too, is easily addressed. If you want to ensure that you get results that at least correspond to the market averages, all you have to do is buy index funds.