In this “one-size-fits-all” world, the lords of investing wisdom praise the almighty index fund – the greatest “set-it-and-forget-it” of them all. Yet, in doing so, are they inadvertently wearing blinders to the goals and objectives of real people? After all, no one wants “Here Lies John Doe – He Beat the S&P 500” on their tombstone.
Many people only see investing through the prism of their 401(k). This limits their vision to all but mutual funds. “For most investors, it’s because they don’t have a choice,” says Merlin Rothfeld, instructor and investment strategist at Online Trading Academy in Irvine, California. “They are locked into a 401k or IRA that only offers mutual funds. This isn’t by accident—it’s by design.”
These retirement plans, now built to make saving even easier, have shifted the emphasis from investing to retirement. Thanks to this shift, more people are saving for retirement.
The downside, however, leaves many without any real experience with investing. This is critical, for, when they retire, they leave the comfortable nest of the plan sponsor’s careful eye. They’ve spent their entire career living with the Swiss Army Knife equivalent of investing, only to be handed a box full of tools with their gold watch.
It’s not as if pooled investing vehicles like mutual funds and ETFs don’t offer benefits. “The reasons ETFs and mutual funds are so popular are ease of use, ability to diversify for small accounts and a combination of costs or technical skills,” says Benjamin C. Halliburton, Chief Investment Officer at Tradition Asset Management in Summit New Jersey. “Investing in individual stocks requires a research team or hiring a research team through a separately managed account by an asset management-oriented RIA.”
Face it, too many have lost the art (and perhaps the interest) in sifting through individual stocks in hopes of finding the golden nugget. Can you blame them?
Everywhere you turn, from the media to marketing, you’re confronted with the commandment “Thou Shall Diversify.” Aristotle suggested to take everything in moderation. Should this apply to diversification, too?
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Rothfeld sees this as a result of “market conditioning. We have all been told to diversify our holdings to help reduce risk over time and it’s easy to think that mutual funds will do the trick. While there may be some truth to this, there are far better options to hold in your portfolio than mutual funds.”
The world once revolved around individual securities. There was a reason for that. Though the interest in stocks and bonds may appear to have waned, those reasons remain just as valid today as they did a generation ago.
It’s all about personal discretion. It’s like the difference between riding public transportation versus calling an Uber. If you want cheap (and inconvenient), take the public transportation. If you want satisfaction of personalized service that gets you where you want to be when you want to be there, call an Uber.
If mutual funds are like the city bus, personalized portfolios of individual stocks and bonds are like chauffeured limousines. “Individual stocks and bonds are probably a better alternative than mutual funds, overall,” says Claudia Gonzalez, an Investment Advisor at Kovar Capital in Lufkin, Texas. “Depending on the investor’s risk and financial goals, an adviser can select the individual stocks and bonds which suit the investor.”
It’s OK to take the bus. You may find the ride relaxing.
But sometimes the bus won’t get you where you need to go.
Sometimes, you need to hail a cab.
When it comes to choosing individual stocks and bonds rather than mutual funds and ETFs, here are five specific reasons to consider:
#1: You wish to manage portfolio risk more precisely.
You have your own specific needs and concerns. These can translate into practical strategies for your investment portfolio. But you may find yourself handcuffed to your mutual fund. It’s designed for the masses, not for the one. What you need to do is to target your risk. Mutual funds don’t do that for you.
“With an individualized approach, you have a better ability to properly diversify your portfolio,” says Benjamin Beck, Managing Partner and Chief Investment Officer at Beck Bode, LLC in Dedham, Massachusetts. “Most funds have more securities (often many more) than is needed to diversify properly. This overdiversification ends up diluting future returns.”
With individual securities, you can map a specific stock or bond to a specific risk. As both your situation and the economic environment changes, you can flip a switch and turn the assignment on and off at will.
“Buying individual stocks or bonds gives investors greater flexibility in controlling the timing of their investments,” says Matt Ahrens, Chief Investment Officer at Integrity Advisory, LLC in Overland Park, Kansas. “Maybe you think the market is high, so you’ll have dividends pay to cash for a while to build up dry powder. Mutual funds and ETFs hate cash, because they’re a drag on performance. Investors do need to understand the importance of risk management when buying individual securities.”
Oddly, it’s the fixed income asset class that presents the most unexpected risk. “A lot of investors who place their money with bond mutual funds are unaware of the relationship between rising interest rates and declining bond values,” says Jeff Mount, President at Real Intelligence LLC in Fairfield, Connecticut.
When rates go up, bond prices (and mutual fund bond funds) go down, revealing the risk to your principal. “Individual bonds are an entirely different animal,” says Ahrens. “When in a rising interest rate environment, individual bonds offer some protection because you knew you would get your money back at maturity as long as the company hadn’t gone under.”
Individual stocks and bonds can address your financial risk with a precision lacking in mutual funds.
#2: You want to manage your tax liability.
Likewise, mutual funds come up short when it comes to managing tax liability. “In general, for tailoring tax considerations, one disadvantage of mutual funds is that investors receiving dividends and realized capital gains will pay taxes on those transactions,” says Robert Johnson, Professor of Finance at Creighton University’s Heider College of Business in Omaha. “You may want to utilize individual stocks and bonds to tailor one’s portfolio to your tax circumstances.”
While this need may not arise in tax deferred investment vehicles like 401(k) plans and IRAs, you will likely also have taxable investments. This is where individual holdings can offer you monetary benefits. “Individual stocks are more tax efficient than mutual funds and should be utilized in taxable portfolios when the investor has enough assets,” says Halliburton. “Individual stock portfolios do not pick up embedded gains. You can tax loss harvest on an individual security basis. In addition, donations of highly appreciated individual stocks can help you avoid capital gains when given to a charity, donor advised funds or a charitable trust.”
If you find yourself in a situation that requires tax efficiency, you may want to reduce your exposure to mutual funds.
#3: You desire a more reliable income stream.
Here again bond funds fail to live up to the promise of “fixed income.” Not only do you experience a potential loss of your principal, but you cannot rely on the fund’s dividend rate to remain constant. This is because a bond fund is a portfolio of bonds, not an individual bond. In that way, a bond fund behaves more like a dividend paying stock.
In which case, why not go for the real thing?
“I like using individual securities when buying high quality, low volatile stocks,” says Ahrens. “Investors who can live off dividends from their investments can build a highly diversified portfolio using individual stocks like Coca-Cola, JNJ, Microsoft, etc. If you focus on the dividend kings then your dividend distributions can help keep up with inflation as the companies increase their distributions.”
This need for income reliability, or at very least a way to continually fund a cash cushion, becomes more important as you approach the end of your working career. “If an investor is nearing retirement, the investor can select individual stocks that provide a consistent dividend payout, also known as blue-chip stocks,” says Gonzalez. “Even with the market fluctuation, these companies still provide a stream of income with their dividend payouts.”
A steady and reliable income will help make your retirement more comfortable. It’s easier to achieve this with individual stocks and bonds rather than mutual funds.
#4: You have an activist proclivity.
Here’s something you might not immediately think of. You want to change the world. Well, it’s difficult to do that if you don’t have a seat at the table.
“One major advantage to owning individual shares is that it permits you to participate in board meetings and to vote your shares at annual meetings,” says Steven Jon Kaplan, CEO at True Contrarian Investments LLC in Kearny, New Jersey. “This would be more important for activist investors or those who like to directly participate in shareholder events.”
With all the current interest in ESG (and the attendant controversy surrounding the definition of the term when it comes to so-called “ESG” funds), you might be better off owning the individual stocks that matter most to you. In fact, you can buy a whole slew of related companies. Or you can avoid a whole slew of related companies.
Halliburton sees assembling a portfolio of stocks as a chance for “customization for ESG and also for concentrated positions. Tailored ESG solutions can directly reflect an investors mandate. You can also create complimentary portfolios that build true diversification around a low-cost concentrated position. For instance, a Healthcare executive can have a complimentary portfolio that invests in everything but Healthcare.”
You don’t have to avoid companies merely for the purpose of reducing your vulnerability to the industry you’re employed in. You might simply choose to avoid them because you don’t like that industry.
“If you don’t want to own tobacco companies, you won’t,” says Beck. “With a mutual fund approach, you have no control over the underlying holdings of the mutual fund. You may end up holding a tobacco company even though you are firmly against it.”
#5: It’s your way to play “Tycoon,” if only on a small scale.
Stock portfolios are more transparent than mutual funds or ETFs. “Investors can see exactly what is in their portfolio on their personal account statement,” says Halliburton. And with this transparency, you get to move the pieces on the chess board of your own personal business empire.
Unlike mutual funds, publicly traded companies denote businesses that generate organic profits through the goods and services they sell. They are your businesses. Literally, you are an owner. As Halliburton says, “Individual stocks represent ownership in real business that produce products and services, are driven by R&D and patents, are enhanced by brands and management teams. These real businesses drive the growth in the intrinsic value which over time is represented in the stock price.”
With stocks, it’s a though you’re the boss. Company management and all the employees work for you. And if you don’t like the job they do, you can fire them by selling the stock.
There’s a certain satisfaction in that. Forget the bus. Forget the chauffer. Drive your own car.
I am a seasoned investment professional with a deep understanding of financial markets, investment strategies, and the intricacies of portfolio management. My expertise stems from years of hands-on experience, continuous learning, and a comprehensive grasp of the ever-evolving dynamics within the investment landscape.
Now, let's delve into the concepts presented in the article:
1. Introduction to Index Funds and Common Investment Approaches:
The article criticizes the prevalent approach of advocating index funds as a one-size-fits-all solution. It suggests that many investors, particularly those tied to 401(k) plans, are confined to mutual funds, limiting their exposure to different investment options. The focus on retirement plans has shifted the emphasis from active investing to long-term savings.
2. Role of Mutual Funds and ETFs:
The article acknowledges the benefits of mutual funds and ETFs, such as ease of use, diversification for smaller accounts, and cost efficiency. However, it argues that these pooled investment vehicles may not be the optimal choice for investors seeking more personalized and precise strategies.
3. Preference for Individual Stocks and Bonds:
The article advocates for a shift towards individual stocks and bonds, comparing them to a chauffeured limousine compared to the "city bus" of mutual funds. It emphasizes that personalized portfolios offer greater flexibility and control over risk, tax liability, income stream, and activism.
4. Reasons to Choose Individual Stocks and Bonds:
- Precision in Portfolio Risk Management: Tailoring risk to specific needs and concerns by avoiding over-diversification.
- Tax Management: Individual holdings can be more tax-efficient, allowing for tax loss harvesting and strategic donations.
- Reliable Income Stream: Individual stocks, especially those with consistent dividends, provide a steady income, essential for retirement.
- Activism: Owning individual shares allows participation in shareholder events, suitable for activist investors.
- Customization and Transparency: Building a transparent, customizable portfolio aligned with personal values and objectives.
5. Ownership and Control:
The article emphasizes the transparency and control that come with owning individual stocks. Investors can actively manage their portfolios, engage in corporate governance, and align their investments with personal values and goals.
6. Analogy – Public Transportation vs. Uber:
The analogy of public transportation (mutual funds) versus Uber (individual stocks and bonds) is used to highlight the trade-off between convenience and customization. It suggests that while mutual funds are easy and convenient, individual portfolios offer a more tailored and satisfying investment experience.
The article concludes by asserting that individual stocks provide a more transparent and satisfying investment experience, allowing investors to actively manage their portfolios and have a direct impact on their financial outcomes. The analogy of driving one's car versus taking public transportation encapsulates the idea that personal control and satisfaction come with individual stock ownership.