Should an investor invest in individual securities or use funds? 

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Should an investor invest in individual securities or use funds?

Stock and bond mutual funds have been popular among investors, and record amounts have been invested in them over the years. The advantages of mutual funds, as stated earlier in this chapter, are the use of professional management, diversification, the freedom to invest small amounts of money, and the ease of buying and selling. For many investors, these advantages far outweigh the disadvantages of mutual funds.

Mutual funds might be the most practical way for investors to buy many types of securities, including bonds that sell in high denominations (minimum investments of $50,000) and to build a diversified portfolio of stocks. The decision of which individual stocks to invest in can be avoided by choosing equity mutual funds.

Diversification achieved by mutual funds minimizes the effect of any unexpected losses from individual stocks in the portfolio. Also, the professional managers of these funds have quicker access to information about the different issues. The managers might react sooner in buying or selling the securities in question.

However, in certain cases, a strong argument exists for buying individual securities over mutual funds. The rates of return on individual stocks and bonds are often greater than those earned from mutual funds. This statement is true even for no-load funds because in addition to sales commissions, other fees, such as 12(b)–1 and operating fees, reduce the returns of mutual funds. By investing in individual securities, you avoid these fees. A study by Malkiel (1995, pp. 549–572) during the period 1971–1991 on the performance of equity mutual funds indicates that on a yearly basis throughout this period, the top-performing funds in one year could easily become underperforming funds in the next year. This phenomenon occurred more in the 1980s than in the 1970s.

Table 14-8
Characteristics of Individual Securities versus Mutual Funds

Individual Securities Mutual Funds
Diversification Achieved only if a large number of securities is purchased. Achieved with a small investment.
Ease of buying and selling Easy to buy and sell stocks at real-time prices during the trading day. More difficult to buy bonds Easy to buy and sell shares. Trades occur only at the closing price at the end of the day
Professional management No Yes
Expenses and costs to buy and sell Brokerage fees to buy and sell. Low to high expenses depending on fund.
Tax planning Easier to predict income and plan capital gains and losses. Can upset careful tax planning owing to unpredictable distributions of income and capital gains.

If you have a small amount of money to invest, mutual funds are a better alternative. A $2,000 investment in a stock fund buys a fraction of a diversified portfolio of stocks, whereas for individual securities this amount might allow for buying only the shares of one equity company. Investing in mutual funds is good strategy if you do not have enough money to diversify your investments and do not have the time, expertise, or inclination to select and manage individual securities. In addition, a number of funds offer you the opportunity to invest in the types of securities that would be difficult to buy individually. Table 14–8 compares some characteristics of investing in individual securities versus mutual funds.

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