FINANCIAL PROBLEM SOLVED!

"I'm leery about mutual funds"

Problem

I have about $1 million in mutual funds for long-term savings. I've heard that most wealthy people have individual stocks, and money managers to watch over them. Am I missing out on profits or tax advantages by having mutual funds? Or are individual stocks too risky?

Solution

Holding individual stocks can be more beneficial, particularly if your money's in a taxable account: By choosing securities that you'll be able to hold for years, you can minimize the capital gains taxes you pay. Theoretically, mutual fund managers could hold stocks long term, too, but if many mutual fund shareholders take their money out at the same time, the portfolio manager may have to sell stocks in order to raise cash. These sales could create short-term gains.

Holding individual stocks also allows you to use tax losses effectively. If a stock is doing poorly, you can sell it and replace it with a similar one, so you can claim the loss and perhaps improve your chance for future gains.

With $1 million, you have enough to reduce risk by creating a well-diversified stock portfolio. The securities you choose should cover several asset classes, such as large-cap, small-cap, and foreign stocks, as well as a variety of industries.

The rule of thumb used to be that you could attain a diversified portfolio with 15 to 20 stocks. Current thinking is that you'd need many more to achieve an optimal balance. I believe you should own at least 50 stocks. And it's best to put a minimum of $5,000 into each holding; otherwise, transaction fees make the investment inefficient. If you're going to have a portfolio of individual stocks this large, however, you should hire a professional money manager.

You also have to consider the cost of investing, though. No-load mutual funds with low expenses—such as index funds—can be less costly than a managed portfolio of individual stocks. The expense ratio for no-load index funds ranges from about 0.15 to about 0.70 percent, depending on the asset class. In contrast, money managers typically charge 0.85 percent to 1.25 percent annually for the first $1 to $3 million you invest. On the other hand, actively managed funds, in which a manager selects stocks in an effort to maximize returns, often have higher expenses: For US equity mutual funds, expenses average about 1.5 percent of assets annually.

Still, if you want to invest on your own and don't have the time to follow individual stocks, or if you don't have enough money to diversify among individual stocks, funds are the way to go. Mutual funds are also ideal for small-cap and foreign equities, even when you primarily own individual securities. Your financial adviser can suggest appropriate funds, if you need help.

You say that your money is already in mutual funds. If they're in a tax-deferred account, you could benefit by selling any funds that focus on large-cap US stocks and having a money manager choose individual domestic large-cap securities for you. Keep mutual funds that invest in small-cap and international stocks.

If your funds are in a taxable account, consider selling only those with losses, assuming that would free up enough money to buy at least 50 stocks. Don't sell appreciated mutual funds; you don't stand to gain by paying taxes and reinvesting. Instead, if you invest more later on, buy individual large-cap stocks in a planned way, to build your portfolio.

Paul R. Temby is a financial adviser with Dowling & Yahnke in San Diego. He can be reached at paul.temby@dyinc.com.

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Paul Temby. Financial Problem Solved! "I'm leery about mutual funds".

Medical Economics

Mar. 7, 2003;80:79.