Addressing the Eternal Question: Should You Buy Stocks or Funds?

Stock investing takes more time, but either way, diversification is key.
Author:
Publish date:

Coke or Pepsi? Fries or onion rings? The Hudson River or the Witness Protection Program?

For budding investors, the biggest decision is usually between stocks and mutual funds.

When people are just starting to invest, they'll inevitably ask whether that money should go into individual stocks or funds.

That decision comes down to time and know-how. To construct your own properly balanced stock portfolio, you'll need the time to do the research and stay on top of each and every selection. You'll also need to know how to pick those stocks and how to build a portfolio that won't blow up in your face.

If you'd rather keep it simple and spend your free time with other human beings, invest in mutual funds.

You can go through the following checklist to see if you should use stocks, funds or both.

Free Time

A portfolio of funds -- particularly index funds that emulate the performance of a stock-market index such as the

S&P 500

-- won't require much maintenance. You're paying someone else to pick the stocks and look after them day after day. With your own portfolio of stocks, you'll have to watch your investments every day and react to news and price changes.

Remember: Fund managers and money management professionals spend their days researching companies and their competitors. If you have a full-time job outside the financial-services business, you surely won't be able to do the same kind of legwork and brainwork between the hours of 7 p.m. and 6 a.m.

Skill Set

In buying individual stocks, you'll need to develop some sort of selection methodology. Why do you want to own it? Is it because of the product the company makes? Is it because of its dominance over its competitors? Do you feel comfortable with how the stock is priced?

"If you cannot answer those questions about individual stocks, you may just be gambling," says Jeffrey Molitor, director of portfolio review at

Vanguard

.

You should also know that over the long haul, you probably won't be able to beat the market buying individual stocks.

"The chances of you coming out ahead because of skill aren't that great," says Terrance Odean, a professor of finance at the Graduate School of Management at the University of California at Davis. "Professionals, on average, don't beat the market."

True. A majority of actively managed U.S. diversified stock funds has been able to beat the S&P 500 index in just eight out of the past 23 full calendar years, according to

Morningstar

.

Sure, 68% of these fund managers are beating the S&P this year. But over time, you're better off owning the index fund than trying to beat the market yourself or find one of the few managers who can consistently outperform the market.

Distributing Risk

You can get a well-balanced portfolio with about two dozen stocks, but knowing how to achieve the necessary diversification is a tougher task.

The academic literature says that a portfolio of 10 randomly selected stocks isn't much more risky than the overall market. In practical terms, you probably want to shoot for 20 to 30 stocks to ensure the right diversification.

But again, this is a portfolio that needs to be distributed over various market sectors. "A portfolio of 16 technology stocks isn't a diversified selection," says Vanguard's Molitor. "Nor is a portfolio of 16 banks." Of course, the same holds true when investing in mutual funds: Holding three funds that focus on the same specialized sector doesn't deliver diversification.

The idea behind diversification is that you own a collection of stocks that won't move in the same direction at the same time. For example, oil stocks will tend to do well when energy prices are high, while airline stocks tend to be hurt by rising oil prices.

Bill Nygren, co-manager of the focused

(OAKLX) - Get Report

Oakmark Select fund, says he doesn't have a magic quantitative formula for diffusing the risk in the fund but he does have measures to avoid too much concentration in any area.

"Once I have one stock that has exposure to one set of risk factors or one industry, I require a substantially higher hurdle for a second stock that will provide exposure to the same set of risk factors."

Every company and industry comes along with a specific set of risks. You need to know them and understand them.

When Nygren started the Select fund (he also co-manages the

(OAKMX) - Get Report

Oakmark fund), the cable TV industry was very attractive but not without its hazards. He had to worry about the risk that the industry's technology would become obsolete or that the government could step in and ruin the business' profitability.

Nygren bought his favorite cable stock but before adding more cable stocks, he weighed the returns that he expected from those companies compared with other stocks in different sectors. Had those returns been equal, he would have been better off buying stocks in other industries to reduce his risk.

If you are trying to determine a decent sector allocation for your portfolio, you can look to a broad index, such as the S&P 500 or the

Wilshire 5000

. The vast Wilshire index, which comes the closest to representing the entire market, has about 30% in technology and 12% in health care. Those weightings can serve as guidelines for the amateur.

Taxation

By buying individual stocks, you will have greater control over the taxes in your portfolio. Mutual funds must distribute all net realized gains to the shareholders every year, which are taxable. You have no control over what the manager is selling during the year.

You can, however, control any buying and selling in your own portfolio. You might not be able to beat the market by picking your own stocks but you can do a better job of managing your taxes. If you one of your picks takes a big hit, you can sell some shares to harness the loss and offset gains you've realized in other investments.

A Combo

If you want to experiment with buying your own stocks, you can just take a small amount of expendable cash -- maybe 10% of your total portfolio -- to start learning rather than putting everything on the line at once. In researching and following the stocks you buy, you'll get an inexpensive education in how the markets and companies work.

"It's fun to buy a stock, watch it go up, sell it and think you're a genius," says Nygren. "But building a portfolio of your own stocks isn't nearly as much fun when the market isn't going up."

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.