Stocks Vs. Mutual Funds: Which is Better?

Instead of picking individual stocks, investors are encouraged to buy mutual funds for diversification and professional management. Are you aware of anybody who got rich investing in mutual funds? No? How about by advising others to invest in mutual funds?

According to the 2009 Investment Company Fact Book, there are 8,022 mutual funds, 646 closed-end funds, 728 exchange traded funds, 865 funds of funds, 368 index funds, 619 lifecycle funds, 1,893 variable annuities, and 1,429 retirement funds. All in all - 14,570. And that does not even include hedge funds. By comparison, there are approximately 7,500 stocks on the Nasdaq and NYSE (including former AmEx).

Granted these numbers are not static: new funds are constantly being created, old ones fold or merge; stocks IPO, merge, spin off, and get delisted; but that does not change the overall ratio much. Besides, not all funds invest in stocks, but generally speaking there are now more stock mutual funds than the stocks they invest in. There is a mutual fund for every flavor: value, growth, income, growth and income, aggressive growth, small cap, mid cap, large cap, dividend payers, sector, foreign, regional, emerging markets...

Security Selection

What's easier (and more fun): to pore over 10,000 mutual funds analyzing returns, managements, objectives, styles, reports, holdings, expense ratios, betas, and quintiles or research AAPL or BIDU?

Market Timing and Rotation

Some "professionals" advise clients to own a fund in each category for broad market exposure. If all mutual funds invest in all stocks, then their collective returns must be market returns less management fees, so broad market exposure is a guarantee of below market returns. Besides, the market favors different styles and sectors at different times. "Broad market exposure" is nothing more than a smokescreen for incompetence. This broad market exposure did not save your portfolio from losing 50% in the recent meltdown, did it?

Window Dressing

There is an old adage on Wall Street: you can't lose your job by losing your client's money in IBM, which means that if an investor looks at a mutual fund's holdings and sees that XYZ is way down, his reaction is - what's wrong with this manager? But if the manager is holding IBM that's way down, the reaction is - what's wrong with IBM? That's why looking at a fund's holdings does not tell you anything because you don't know when a stock was purchased and at what price. At the end of each month and quarter, fund managers engage in the window dressing ritual of buying stocks that have done well and ditching losers so that statements look good. Does not mean your fund has made any money in these stocks.

Buy High, Sell Low

A mutual fund buys when it gets money from investors and sells when investors want their money back. Investors are notoriously bad at timing, buying when they should be selling and selling when they should be buying. It means that funds often buy overpriced stocks and sell bargains.

The bottom line: most mutual funds underperform the market. If you do not want to settle for institutionalized mediocrity, learn how to pick stocks.