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GETTING GOING / By JONATHAN

W.S.J., 9-24-96

Yes, Stock Mutual Funds Are Attractive, But Don't Abandon Individual Stocks

Stock mutual funds or individual stocks?
In this grand debate, investors have voted with their wallets, and the funds are winning in a landslide. A well-deserved victory? After years of favoring funds, I'm having second thoughts. Here's why individual stocks deserve another look:
Commissions Are Coming Down For years, no-load stock funds seemed like the cheapest way to invest if you had only a modest portfolio. Sure, you had to pay the fund's annual expenses, which might nick you for 1.4% a year, or $14 for every $1,000 invested.
But this seemed like a trifling cost, given the trading advantages that funds enjoyed. Like individuals, funds pay brokerage commissions when they buy and sell shares. But unlike small investors, funds trade at rock-bottom institutional commission rates.
Lately, however, commission rates for small trades have dropped so much that funds no longer enjoy a huge cost advantage. Some discount brokers charge less than $30 for smaller trades, while those who venture onto the Internet can buy and sell for under $15.
Some publicly traded companies will even sell their shares directly to investors, with few fees involved. Result? If you trade infrequently, owning individual stocks can be far cheaper than buying funds.
Moreover, as a small investor, you don't have to fret about how your trading affects a stock's price. That sure isn't the case with funds, which struggle to invest their ever larger portfolios. Funds can drive up a stock's price when they buy and drive it down when they sell, thus making it costly to amass and unload shares.
Uncle Sam Can Be Kept at Bay If a fund wants to attract investors, it needs to generate an impressive pretax return. This, after all, is the number that appears in newspaper mutual-fund tables, and fund advertisements, and surveys of fund performance.
But shooting for the highest possible pretax return may hurt some shareholders. Suppose, for instance, that a fund sells a winning position to buy another stock, which does even better. The fund's pretax return is higher.
But shareholders who own the fund in a taxable account may be worse off. The gain from selling the old stock position will get paid out as a capital-gains distribution, unless the fund has an offsetting loss. Taxable shareholders then have to pay taxes on this distribution, even if they reinvest the distribution back into the fund. After figuring in the tax s pa taxable shareholders may have fared better if the manager had hung onto the old stock.
You won't have this problem, however, if you stick with individual stocks. Don't want to pay any capital-gains taxes this year. Don't sell any of your shares.
RETURNS CAN BE JUST AS GOOD I believe the market is reasonably efficient. Admittedly, there are initial public stock offerings that soar to ridiculous heights and penny stocks in which hype triumphs over value.
But if you dabble in larger companies, you probably won't go too far wrong. Every day, veteran portfolio managers study the market's blue-chip stocks, reach entirely different conclusions and end up buying and selling from one another. Thanks to all this activity, stocks tend to be fairly priced.
Indeed, it bargains were readily available and easily spotted, stock-fund managers would no doubt put together outstanding track records. The reality? Over the past 10 years, diversified U.S. stock funds gained an average 12.1% a year, compared with 13.8 % for Standard & Poor's 500-stock index, according to fund researcher Lipper Analytical Services.
What does this mean for small investors? If you buy individual stocks and stick with bigger companies, you too are unlikely to beat the market. But if you hold down costs and pay attention to taxies, you may do somewhat better on your own than you would with funds.
But Risk Is Still a Problem Our happy story, however, doesn't have a happy ending. While I believe individual stocks' are increasingly attractive, I would stick with funds, for two reasons.
First. it's less nerve-racking. You may have to live with a fund's share-price gyrations. But at least you don't see all the turmoil within the fund's portfolio. If you owned the individual stocks, there's a risk that you might make panicky decisions and trade too much, thereby crimping your returns and eliminating the tax and cost advantages of owning Individual stocks.
Second. if you buy individual stocks, It's difficult to diversify. By diversifying, you eliminate the risk that your portfolio will get clobbered by a few rotten stocks. Many folks opt for funds when investing in small companies and foreign stocks, because getting decent diversification is just too tough.
But what about blue-chip stocks? Funds are still your best bet, argues Gerald Newbould, a finance professor at the University of Nevada at Las Vegas. He reckons that you need at least 60 blue-chip stocks to be well diversified, far more than the eight to 20 stocks that Is often recommended. If you own fewer than 60, "you may do better than average, but you could also do extremely badly," Mr. Newbould says. "You're running a risk."

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