Stocks or Mutual Funds

An investor has an option when it comes to buying equities, individual stocks are a mutual fund that contains a group of stocks. The mutual fund gives diversification in a variety of stocks. An individual stock has no diversification and has considerable more risk because it has unlimited upside potential and can theoretically go to $0.00. For the savvy investor which one is best an individual stock or a Mutual Fund? My answer is a mutual fund.

Reasons to Own a Mutual Fund

While a stock has considerable risk a belief seems to exist that a person can get sufficient information to know when to buy or sell it. I think this is absolutely false. Let's look at the events around General Electric, GE on Friday, April 11th.

Certainly GE has been a darling on Wall Street. On Friday, April 11th, GE announced earnings. Let's go through the sequence of events:

• The belief on Wall Street was that earnings would be good and reasons were given by the experts that make a lot of money giving investor advice.
• Earnings missed expectations and a positive spin was put on the results.
• By the end of the day the stock dropped 13%, the worst 1 day decline since the 1987 market crash. This fact came from Barron's April 14, 2008 publication.
• Barron's wrote a wonderful article in this publication, "At GE, One Bad Quarter Doesn't Spoil the Story" by Andrew Bary

The questions are:

1. What would you have done if you would have listened to the advice prior to the earning announcement? Lost 13%.
2. Why would Barron's publish the article? To sell more publications.
3. Why would Andrew Bary write the article? To make money.
4. Do people at Barron's or Andrew Bary own GE stock? Most likely.

Bottom Line: Are you getting the total unbiased information from these experts? No. If these experts can't get it right on GE, what makes you believe they will get it right on any stock that you own.

Cost of Mutual Fund Fees

In a previous blog we talked about fees and the transfer of money from your pocket. How much money are we really talking about?

Let's look at an example of $10,000 being invested at an average annual return of 9%. This means that every 8 years money doubles, from the rule of 72. You buy a fund that has a 8% front end load which means that you just handed over $800 in sales charges. Since it is a loaded fund the 12B-1 fee can be as much as another 0.5% per year or $50 the first year. We have a total of $850 in the first year.

You think no big deal $850, this mutual fund is great and I will get this back in no time. Wrong, this is a big deal!!!!!! You now lost the opportunity to make money that could go into your pocket.

How much did you lose with an 8% front end load and an extra 0.5% 12B-1 fee? For ease in illustration let's look at this every 8 years.

8 Years Later: $2,100 ($1,600 from load and $500 from fees)
16 Years Later: $4,800 ($3,200 from load and $1,600 from fees)
24 Years Later: $10,200 ($6,400 from load and $3,800 from fees)
32 Years Later: $21,000 ($12,800 from load and $8,200 from fees)

You lost your original $10,000 investment in about 24 years. OUCH!!!!!! The amount of loss grows rapidly by doubling in the next 8 years. The cost from fees becomes a bigger portion with time.

What is the value of $10,000 invested at 9% before fees and net after subtracting fees?

8 Years Later: $20,000 - $2,100 = $17,900
16 Years Later: $40,000 - $4,800 = $35,200
24 Years Later: $80,000 - $10,200 = $69,800
32 Years Later: $160,000 - $21,000 = $139,000

Bottom Line: This one is simple, BUY NO-LOAD MUTUAL FUNDS. More than 10% of your investment is consumed in loads and fees that should be in your pocket.

Mutual Fund Fees

Mutual funds investment companies deserve to be paid for their efforts and the returns that they obtain for their client. What are these fees? Fees can be put into 3 categories.

The first is management expense to do the investing. This is the cost of doing business.

The second is sales charges that is paid to others to sell the product such as a distributor or selling group member. This charge can be as much as 8.5% and benefits the mutual fund company not the investor. From the previous blog, it can hurt the investor in both cost and mediocre fund performance. This can be avoided by buying a no-load fund.

The third is 12B-1 that is an annual fee to promote and distribute fund shares. A no-load fund can charge up to a 0.25% annual fee. A load fund can charge up to a 0.75% annual fee.

Sales charges and high 12B-1 fees can cost you a lot of money. STOP paying them and put the money in your pocket.

In the book, Random Walk Down Wall Street, some research showed the impact of these fees.

1. From 1977 - 1997 an index fund beat the average fund by 2% after fees are considered.
2. From 1988 - 1998 less than 20% of the mutual funds beat an industry average index after fees.

Bottom Line: Either buy a low fee index fund or one of the top 20%. It's your money, put it in your pocket.

Mutual Fund Size

When investing in a mutual the size, or assets under management, is important. A small fund may not have the ability to properly diversify. Too large of a fund may not be able to achieve the anticipated performance. How can this be?

By definition a mutual fund that claims to be diversified must meet the 75-5-10 test. 75% of the assets must be invested in securities of other issuers. 5% or less of the assets may be invested in any one company. 10% or less may be owned of any company's outstanding voting stock.

Why is this important? Once a large mutual fund buys the limit of a company and still has money to invest it can either hold the cash or invest it. Since the purpose of a mutual fund is to invest, it finds another company to invest in and buys. As more money comes in, the stock of more companies must be purchased.

With time the largest mutual funds will start to look like an index fund as they have to purchase lots of companies. The only problem with buying the largest mutual fund instead of an index fund is the amount of fees. Index funds have a lower fee structure. If the choice is either one of the largest mutual funds and pay higher fees or an index fund, go with an index fund.

Bottom Line: If you are going to pay the money for an investment advisor, the advisor should understand the importance of an optimum fund size and not necessarily buy the largest mutual funds.