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Investment Consult: Play it smart--stick to funds


Shares in hot companies can be tempting. In good times and bad, though, funds offer big advantages over individual stocks.


Investment Consult

Play it smart—stick to funds

Shares in hot companies can be tempting. In good times and bad, though, funds offer big advantages over individual stocks.

By Lewis J. Altfest, PhD, CFA, CFP

While many individual stocks fared poorly over the past 12 months, mutual funds were hard hit, too. And so far this year, the returns of most actively managed domestic equity funds have slightly lagged behind those of the Standard & Poor's 500 Stock Index. These funds have also underperformed the market benchmark over five and 10 years, by a more significant 3.2 and 1.6 percent, respectively.

You may be asking yourself why you're paying professional fund managers to invest your money, if all they've managed to do is lose it.

Nearly every week, a client asks me the same question. The sharpest argue that choosing their own stocks offers distinct advantages: They don't have to pay fund company management fees, which can cost as much as 2 percent of assets per year; they can use a discount broker, such as Charles Schwab or E*Trade; and they can better manage their tax liability. After all, if they don't sell any of their winning stocks, they won't owe Uncle Sam capital gains tax. By contrast, most equity mutual funds distribute capital gains annually—even when the fund has had a negative return.

All valid points. However, there's another side to the story.

As I mentioned last year in this column,* you need a heavy dose of financial savvy, plus time and discipline, to monitor your stocks. Many physicians lack all three. I've seen doctors invest in what they perceive to be "safe" stocks, only to hold them well past the time when they should have sold.

I've also found that even investors who know how important diversification is wind up concentrating on a category of stocks that either appeals to them personally or is hot at the moment—technology companies, in recent years. Other do-it-yourselfers focus on an even smaller sector of the market—health care or dot-com companies, for instance—or on domestic growth stocks. They often totally ignore foreign stocks, mid-cap and small-cap offerings, and real estate investment trusts, all of which should be part of any balanced portfolio.

As for the tax issue, many fund managers tell me they're now paying more attention to the tax consequences of their trading. If the IRS has been taking big bites from your investment gains, you may want to focus on no-load mutual funds that minimize capital gains-producing trades. Strong Growth and Income­Investor Class (800-368-1030) and Baron Small Cap Fund (800-992-2766) take this approach. Strong's five-year average annualized return through April approximates that of the S&P 500 (16.1 percent).

Barron Small Cap, which launched in 1997, has had a 9 percent annualized return since its inception.

Here's the main reason I'd discourage eschewing mutual funds in favor of stocks: It's difficult and expensive to diversify your portfolio with individual stocks. You'd have to own more than 100 to match the diversity you'd get from the typical actively managed domestic fund. To buy round lots—100 shares each—of that many stocks, you'd spend a small fortune. On the other hand, you can buy a stake in a well-diversified mutual fund for as little as $500.

Does this mean you shouldn't buy any individual stocks? Not necessarily. Many successful investors own a blend of stocks and mutual funds. They take a few hours each week to research and monitor their holdings, often with a financial planner's help. But people who don't have the time or skill to evaluate individual stocks—meaning most investors—should use mutual funds to cover all of the major equity categories: large-cap, mid-cap, and small-cap stocks, growth and value, foreign and domestic.

If you're in this latter group of investors, you should hold no more than 20 percent of the value of your portfolio's equities in individual stocks. In fact, let the percentage go that high only if you've consulted a financial adviser about your purchases. Let mutual fund managers make the decisions regarding the rest of your stock holdings. A smart manager is cooler under pressure and apt to be more patient and objective than the typical individual investor.

*See "The pros and cons of managing your own money," June 19, 2000.

The author, a fee-only financial planner, is president of L.J. Altfest & Co.( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.


Lewis Altfest. Investment Consult: Play it smart--stick to funds. Medical Economics 2001;12:28.

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