Some Things to Consider Before Becoming Your Own Fund Manager

In recent weeks, a barrage of press stories has appeared, suggesting investors en masse are starting to pull their money out of mutual funds to pick their own stocks.

But if you are going to abandon mutual funds for the stock market, your ability to pick good stocks is only one of the issues you need to consider.

If you plan to put all or a large portion of your assets in stocks, you need to think about the construction of your portfolio, its risk and the time you have to spend researching stocks, among other things. On balance, you may discover you're better off if you keep at least some of your money in your funds.

I recognize a lot of you have had success investing in individual stocks, but there are certainly things people should keep in mind if they've never done it before. Let's look at some of them in detail:

Diffusing Risk

Diversification. You read about it everywhere, but what does it mean? It's a portfolio strategy that is designed to reduce risk exposure by combining investments that are unlikely to move in the same direction.

It's certainly easier to achieve diversification in mutual funds than in your own stock portfolio. A $5 billion fund will likely own more stocks than you will, and thus offer greater diversification.

Many professionals argue you can indeed have a diversified portfolio with about two dozen names. But that is assuming you know how to achieve it.

Many fund managers are trained in these diversification techniques. These ideas are not impossible to learn, but it requires a lot more rigor than just picking a few stocks out of a personal finance magazine. You need to know basic statistics and a touch of modern finance theory. "Get out the books to understand portfolio theory and covariance," says Terrance Odean, a professor of finance at the Graduate School of Management at the University of California at Davis. (Covariance, by the way, is a statistical measure of the relationship of two variables.)

You will need to know how the movements of certain stocks and industry groups can be offset by others. For example, a computer stock might do well when interest rates are falling, and an oil stock might do well when interest rates are rising.

If you can't look at a portfolio of stocks and understand the correlation between their likely price movements, you probably shouldn't be running the vast majority of your assets by yourself.

Unfortunately, the tools you need to truly ascertain a portfolio's diversification are virtually unattainable for the average retail investor.

"Institutions hire me to do that for them," says Andrew Lo, a professor at the MIT Sloan School of Management and director of the Laboratory for Financial Engineering. "And believe me, I charge them a fair amount of money." But Lo thinks that over time, as competitive pressures increase, brokerage firms will provide these tools to their retail customers. Right now, "it is so cheap to get access to information. The value added is going to be in helping individuals interpret that information."

The whole idea of diversification is to reduce risk and boost returns. But gauging and quantifying the risk of your own portfolio are bigger tasks than looking up the Sharpe ratio for your funds on Morningstar.

Fighting Bad Timing

You might be moving into stock investing with a built-in weakness. Individual investors aren't very good at timing their stock selections, asserts Odean.

According to a study he conducted from 1987 through 1993 in 10,000 random accounts at a large discount brokerage firm, the stocks people bought tended to do worse than the stocks they sold. "That is not so good," Odean says.

Over a 252-trading-day period (about one year), the stocks people purchased underperformed the ones they sold by 3.3%. And this was not counting commissions and the bid-ask spread.

You've Got the Money; Have You Got the Time?

If you are going to start picking stocks, you'll have to invest time more than anything. If you have a full-time job outside the financial services industry, this may be a precipitous proposition.

Mutual fund managers and other money management professionals are spending their days researching companies, their competitors and vendors, in the office and out. "Do you think you can do that on your own?" asks Bryan Olson, director of research at the Charles Schwab's Center for Investment Research. It is no accident that T. Rowe Price (TROW Quote) has about 50 analysts on its staff in addition to about 50 fund managers.

The amount of information available to individuals today is unbelievable. You might be able to listen to conference calls for some companies, but are you going to be able to take time out of your day to do that and then act on what you might hear?

"If you don't have the time, you shouldn't kid yourself that you are going to be able to make finely honed decisions," says Andrew Lo.

As an employee of TheStreet.com, I am not allowed to own individual stocks, but I couldn't do it if I wanted to. I've had a 30-pound bag of laundry sitting in the middle of my floor for about two weeks now. I would never be able to find the time to read a research report.

What You'll Never Know

Even in the age of the Internet, it's unlikely individual investors will get truly critical information on companies. Large institutions have not only expansive research departments and all the electronic tools you can imagine, but also vast amounts of money to invest, which will get them access to companies or early warnings from analysts that the average investor never will. Institutional investors have much closer contact with companies and are able to recognize trends much earlier.

Any major mutual fund company might have numerous company management teams traipsing through its offices on any given day. Companies will convey their financial performance, strategy and vision to these large investors. These are the types of discussions that you may never hear. By the time you read a story about a company in the newspaper, the big money has already digested the information and made its decisions.

Some argue that this lack of information and access is even more pronounced when you start talking about international and small-cap stocks, areas where the markets are less efficient and where there is less public knowledge. "Are you going to know these companies well enough?" asks Olson. "You can't turn on CNBC every night and hear about them."

As for the information that you do hear, particularly over the Internet, you will need to be able to differentiate between what is relevant and what is not. Not an easy task.

Play Money

If you want to try your hand at stock investing, you may want to start with a small portion of your portfolio, say 10%. Of course, this should be money you can afford to lose. That way, you retain the nice foundation you have built in your mutual funds, while getting the opportunity to invest in individual stocks.

Maybe Stocks Aren't The Answer

I am not underestimating the reality of underperformance in mutual funds. The numbers speak for themselves. But if you are truly unhappy with your fund, you may want to shop for a new one. Find one that costs less and has lower turnover. If you hate your Cadillac, you might go out and buy a Honda, not a body shop.

And one other thing. If you've got your money in a mutual fund, at least you have someone to blame when it goes bad.

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