Tahoe-Truckee Market Beat: Are mutual funds better than individual issues?
If you ever get a hot stock tip from a friend or a neighbor, be careful. It might be a good idea, but you need to understand how much exposure your portfolio can stand to any one individual stock.
One advantage to using mutual funds is the diversification you can achieve with even a limited amount of money. Remember the old saying, “Don’t put all of your eggs into one basket”? By using a mutual fund, you diversify your risk.
That doesn’t mean that investors should never buy individual stocks, just that you should know how much risk you can take if the stock goes down.
One advantage to owning individual stocks is that there is no ongoing expense after the initial commission is paid. Lowering your investment expense can enhance your long term returns. By using low cost index funds and stocks, you can keep that investment expense low.
There are also advantages and disadvantage to using funds for fixed income investors. One advantage is diversification. When investing in investment grade bonds, diversification is not nearly as important as when investing in junk bonds or stocks, because the default rate is very low.
Using a fund for diversification can be very helpful when investing in high yield or junk bonds because the default rate in yield bonds can be very high in times of recession. The default rate can exceed 40% for low rated bonds.
With investment grade bonds the default rate is very low. U.S. Treasury bonds are backed by the full faith and credit of the United States government, so even if you have a relatively small amount of money investing some in individual US Treasury bonds is basically risk free.
A big disadvantage to using mutual funds for your fixed income exposure is that unless you use stated maturity funds, you do not have control over your maturity dates.
By selecting your maturity dates you can minimize the risk of getting caught in a rising interest rate environment. Long term bond funds can suffer serious losses in times of rising interest rates.
In general, the decision to use funds or individual issues depends on several factors, including the size of your portfolio, whether you’re considering stocks or bonds and your outlook for the investment you’re evaluating.
There are always advantages and disadvantages to both of them, including expenses, diversification and maturity dates.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.
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