Should I invest in mutual funds or individual stocks and bonds ?

This article was first posted on June 1, 1998, updated August 7, 1998

Many people just assume that mutual funds are the best way to save for retirement, but like most "conventional wisdom", it's often wrong. You can dramatically reduce your investment expenses by buying individual stocks through a discount broker and you can completely eliminate fees and commissions on your bond purchases by opening a Treasury Direct account

A million dollars isn't what it used to be, but $10,000 is still real money.

On a $1,000,000+ IRA account, I'm currently paying less than $200 per year in fees and commissions. (I know, a million dollars sounds like a lot, but readers familiar with "safe" withdrawal rates (See, "What is the maximum safe withdrawal rate in retirement?") will recognize that a $1,000,000 nest egg will safely support only a $40,000 annual withdrawal. Good money to be sure in most parts of the country, but far short of what's required to fund a "Lifestyle of the Rich and Famous.") If you had a $1,000,000 in the Vanguard S&P500 Index Trust you'd be paying 0.20% of assets or over $2,000 per year in management expenses. The average equity mutual fund has fees and expenses of over 1.00% per annum. So a $1,000,000 IRA account holder would be paying over $10,000 per year in fees and expenses for the privilege of underperforming the market. (Between 85% and 95% of mutual fund managers underperform the S&P500, depending on who's doing the counting.) If you can capture the $10,000 per year difference, you could easily pay for the lease on a new Lexus. That's right, you could be driving a new luxury car instead of your mutual fund manager.

What about diversification ?

One of the big advantages of mutual funds is diversification. Your mutual fund manager pools your money with thousands of other people and builds a portfolio containing hundreds of securities representing companies in dozens of industries. It's very prudent to avoid putting all your eggs in one basket.

Unfortunately, too much diversification isn't good for you. You don't need to hold hundreds of securities to be properly diversified. Nobel Prize winner William F. Sharpe published on article in 1972 on the effect of diversification on nonmarket risk.("Risk, Market Sensitivity and Diversification," Financial Analysts Journal, January/February 1972, pp. 74-79. For an extensive list of Prof. Sharpe's publications Click here.) As the graph below shows, increasing the number of securities held does reduce your risk, but the reduction becomes negligible once the portfolio reaches 25 or 30 securities, spread across several industries. Indeed, the plot becomes asymptotic at the level of 35 holdings.

If you need only 35 securities to be completely diversified, why is your fund manager holding 200 securities in your mutual fund?

• He can't buy enough stock in the companies he likes, so he has to add second and third rate issues to remain fully invested.

  Even if your mutual fund manager is a bona fide genius, it's unlikely he has more than 15 or 20 good investment ideas a year. No less an authority than Berkshire Hathaway's Warren Buffett admits to maybe 1 or 2 good ideas per year. You want your mutual fund manager's best ideas, not number 200 on a list with a lot of "jetsam and flotsam."

  The main reason your mutual fund manager has 200 stocks in your fund is he can't buy enough of the stocks he likes. Once a fund gets too large, the manager has to buy large capitalization stocks for liquidity. If your fund is part of a large mutual fund complex like Fidelity, there are restrictions on how much of any one stock Fidelity can hold. So if Fidelity already has its quota, and your fund manager wants to add the security to his portfolio, he has to wait for one of the other Fidelity funds to sell its shares. This type of situation doesn't increase your investment returns.

If I don't use a mutual fund, how do I buy stocks?

The discount brokerage industry and the Internet have combined to force commissions down to virtually zero. You can easily find any number of firms that will charge you a commission of less than $10 to buy or sell 1000 shares of IBM. Ten years ago the lowest commission on that transaction would have been nearly $1,000. Putting together a portfolio of 20 securities using an Internet discount broker should generate total commissions of between $100 and $300, depending on whether or not you use limit orders. (For more information on discount brokers see Gomez Advisors web site.)

How do I decide what stocks to buy? I don't have time to become an amateur securities analyst.

Your local public library probably has two excellent reference guides; Value Line Investment Survey, and Standard & Poors, The Outlook. Both of these guides have recommended portfolios of 15 or 20 stocks, covering 10 or more industries, that you could adopt as your own retirement fund. While you will have to visit the library once or twice a month for updates, this represents an excellent, cost effective alternative to an actively managed mutual fund.

The other advantage of Value Line and The Outlook is that they don't contain the bias of a full service brokerage firm's recommended list. While Merrill-Lynch and Smith Barney rarely have anything negative to say about a stock, (It might hurt the firm's chances of winning lucrative investment banking business from the company in question.) Value Line and The Outlook rank the stocks they cover from 1 to 5, and they have about as many 1's as 5's. They're not shy about sharing bad news with their subscribers.

In comparing Value Line and S&P's The Outlook, I've found that The Outlook changes the securities in its portfolios less often than Value Line. For example, during the 6 month period ending May 20, 1998 The Outlook only changed one security among the 23 issues contained in their Group 1 and Group 2 portfolios. During the same period, Value Line changed 5 securities among the 20 issues in Portfolio 1: Stocks for Performance, 4 securities among the 20 in Portfolio 2: Stocks for Performance and Income, and 1 security in Portfolio 3: Stocks for Long-Term Growth. Standard & Poor's The Outlook's low turnover approach limits the fees and commissions required to keep your portfolio current.

How should I buy bonds?

The absolutely cheapest way to buy bonds is through a Treasury Direct account where you deal directly with the US Treasury and currently pay no fees or commissions as long as your account is less than $100,000. If you have more than $100,000 to invest in bonds, you can open multiple accounts to keep the balance in each account under $100,000.

Dallas Morning News financial columnist Scott Burns has compared the performance of "big government mutual funds" vs. buying and holding 5-year Treasury notes. His Big Government Fund Report shows that over the past 5 years, you would have done better buying 5-year Treasury notes instead of putting money in a government bond mutual fund. This is hardly surprising. Almost the only way a manager can add value to a government bond fund is by reducing expenses. If you buy from Treasury Direct you've reduced your expenses to zero. Even a genius bond fund manager will have trouble beating that!

One other advantage of holding individual Treasury securities instead of government bond funds is that you're guaranteed to get your money returned to you when an individual Treasury security matures. Since bond funds don't have a maturity date, there is no guarantee you'll get your initial investment returned to you at any time in the future. If interest rates rise, you'll likely get less than your initial investment.

Mutual fund management fees for government bond funds aren't appreciably lower than for corporate or municipal bond funds -- even though much less work is required to manage a government bond fund. Since Treasury securities have no default risk, a government bond fund manager doesn't need to spend any time analyzing credit risk. Corporate and municipal bond fund managers on the other hand spend a lot of time worrying about credit risk.

Mutual funds may be appropriate for investing in corporate, municipal, or "junk" bonds. These investments have higher yields (and more risk!) than Treasury securities of the same maturity. An individual is at a great disadvantage in buying these securities because of high commissions and large spreads between the bid and ask prices. However, you need to be very careful in selecting a bond mutual fund. For instance AAA corporate bonds currently yield about 0.5% more than Treasury securities of the same maturity. If you pay more than a 0.5% annual management fee for a corporate bond fund, you would end up with a lower yield than a Treasury security -- even though you now have the added risk of holding a corporate bond. Even a corporate bond fund with the lowest management fee, 0.28% of assets, would leave you with only a 0.22% premium for holding corporate bonds over Treasuries. That might not be enough to compensate you for the added risk of holding corporate bonds. When the difference in yield between corporate and Treasury securities is small, investors are usually better off buying the Treasury securities since they can be purchased at no cost through Treasury Direct.

Should everyone buy individual stock and bonds instead of mutual funds ?

While this strategy will cut expenses and increase returns for many investors, the size of your portfolio is the most important factor in judging if its right for you.

The Treasury Direct program recently reduced the minimum investment for Bills and Notes to $1,000. The minimums had been $10,000 and $5,000 respectively. This change should open the option of direct purchase of Treasury securities to almost everyone.

You probably need a minimum of $100,000 in stocks before the costs of assembling a 20 stock portfolio would be less than the $200 annual expenses (0.20% of assets) in Vanguard's S&P500 Index Trust. Of course, you will see even greater savings after the first year since you should only have to replace 1 to 5 securities per year to keep your portfolio up to date.