The question new and seasoned investors have puzzled over for decades is whether the better investment strategy lies in mutual funds or individual stocks. The answer is like comparing apples and oranges. They’re both investments in businesses (with some exceptions) but a better analogy would be apples to apple pie. They’re both composed of the same basic ingredient stocks but mutual funds, like a good apple pie, has more than one kind of apple baked into it.
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More Pie Please
Apples and apple pie may not be the best analogy in the world but the point is that mutual funds are made up of multiple stocks so their exposure to risk is spread across a wider base of companies. So if one goes bad, the rest of the fund stays afloat. This built in safety feature works best for widely indexed funds that are invested in companies of different types, while sector funds invest in different companies in a particular industry.
For example, tech companies were fine until you remember the tech bubble of the 90’s where tech stocks as a whole fell through the floor. There have been other industry wide bubbles and crashes and stalls and falls and well you get the picture. The same is true for more widely diversified funds. Think of the 2010 Flash Crash where the Dow dropped 1,000 points in a single day or the bear market of 2007 where stocks dropped 20%.
Bulls and Bears
Investing in individual stocks does not protect you from the ups and downs of the market any more than mutual funds it just makes the fluctuations more personal because you picked the stocks yourself. DIY investing is more sophisticated now than it was even 20 years ago where individual investors by and large waited for the newspaper to check stock prices once day and called a broker to place a buy or sell order.
Thanks to the internet, small investors have an incredible array of tools and resources at their disposal, including in depth research and analysis. All that information poses it own set of risks, chief among them is the danger of information overload where investors become obsessed with minutiae and fall to see the proverbial forest for the trees.
Warren Says…
Warren Buffet has two separate quotes that work perfectly together to sum up a sound investment strategy: “You don’t have to be a rocket scientist” and “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Regardless of whether you go it alone or invest in mutual funds, the most important thing you should do is your homework, learn the ABCs of investing and your chosen method. With the right knowledge you really don’t have to be a genius to be successful.
Determining which investment strategy is right for you comes down to having an honest discussion with yourself about you. What you want from your investments and your level of commitment are the two primary areas of conversation that must be addressed before you begin. Having a clear plan will enable you to stay focused and will keep you grounded.
Your Investment Objectives
Being rich is not an investment objective, it’s a dream. Investment objectives fall into two categories. The first includes what you want to do with the fruits of your investments, retire to an island, pay for children’s college, leave a financial legacy etc.
The second kind of investment objective is about your willingness to take risks in your finances. This group of investment objectives includes things like how much you want to invest and what level of risk you are willing to take. Armed with this information you can move on to other questions like commitment.
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When it comes to investing, commitment means time. How much time are you willing and able to invest in learning to invest and learning about investments. Buying a stock is about more than just the price, to quote Warren Buffet again “You don’t have to swing at everything, wait for your pitch.”
Not swinging for the fences with every pitch means learning to read the field and the ball which in this case is understanding the value of a company, not the price of its stock and understanding how the market treats that information. If you don’t have the time to learn and stay on top of these things, then DIY investing may not be for you.
While mutual fund investing may not require as much of a time commitment as DIY, investing there is still a learning curve during which you have to invest your time before you invest your money so that you can make the best possible investment decisions. If your time is so short that you can’t spare any perhaps you should consider a savings bank.
Diversify, Diversify, Diversify
Whether you choose to go DIY or mutual funds, the best course of action is to diversify your portfolio. Putting all your investment eggs in one basket is a recipe for disaster and leaves you vulnerable to not only the winds of change but the gentle breezes of uncertainty.
Diversification also provides a great hedge against bad times. Even during the horrendous bear market of 2007 or the great crash of 1929 not all stocks lost value, many went up and over time almost all recovered and surpassed where they were before the crash. By being a diversified investor either DIY or mutual funds offers a greater likelihood that in bad times you will still have some positive performers to cash in if needed.
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