For me, I have always been a fan of owning common stocks directly instead of mutual funds. Why? First of all, you have absolute ownership of your shares which can be collateralized should you need to do so. Secondly, direct ownership takes away any risk associated with the possible insolvency of a mutual fund company itself. Thirdly, as a direct shareholder you will receive the voting proxies and company reports. In this way you are much more involved in understanding who and what you are investing in. By voting the proxies yourself you become involved in some of the corporate decision making.
In addition, by owning a pooled asset, which mutual funds are, you subject yourself to the whims of others who you do not control. For instance, during the 1987 and the DotCom crashes, many investors panicked and sold their mutual funds. Because fund managers didn’t have enough cash on hand to redeem those shareholders who sold, they were forced to sell some of their stocks in a declining market. When a market is under severe downside pressure and investors are redeeming their shares, the stocks that big fund managers often sell are the ones where there is the most liquidity. That is, they sell the best of their stocks because those stocks are not declining the most. Thus, when they sell a large block of stock on the market, the block will not drop the price of the stock as much as a stock that has less liquidity – i.e., a stock whose prices is already down sharply, has a lot of sellers in it. Back in 1987 when the dust settled, many of the good stocks held in funds were sold while many of the worst ones remained. The same happened to junk bond mutual funds in the late 1980s.
For those who say that mutual funds are the best way to be diversified, they ignore or are unaware of the studies that have demonstrated that owning more than 12 stocks in a portfolio will give you no more risk avoidance. For decades since the turn of the century great market investors from Jessie Livermore to the current William O’Neil have preached the rewards of picking ten to twelve good stocks instead of owning tens or even hundreds (through the ownership of multiple mutual funds that invest in different areas of the market). In my opinion, owning tens or even hundreds of stocks dilutes performance without decreasing risk.
There are many people who have only owned mutual funds and no little or nothing about the companies they are investing in, thereby, extracting themselves from the very process of understanding the businesses where there money is invested, why, and how to do it. To me it’s a little like only eating prepared food, instead of picking out the freshest and sensing all that comes along with cooking and preparation from scratch. Not to mention the good health that comes along with it.
Now I am not saying that mutual funds are bad investments. To the contrary, if you are building a portfolio with smaller amounts of money, mutual funds may be the only way that you can diversify. It also may be the case that you have no interest in knowing much about the companies you invest in, voting and so forth. It might more comfortable for you to own a broad based or even targeted fund and if that makes you sleep better at night, then it is right for you.
Finally investing is very personal and is always dependent upon your attitudes, objectives and risk posture. Knowing what you are getting into from the beginning is a must. When comes to asking questions, there are no dumb ones—just ones that never get asked.
Quote of the Week: “The difference between a successful person and others is not a lack of strength, not a lack of knowledge, but rather a lack of will.” — Vince Lombardi
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.