Mutual funds, are often claimed to have two major advantages over direct stock purchases:
1. They provide the benefits of diversification for small and medium investors, who would otherwise be unable to afford it.
2. They provide small and medium investors with professional management, they would otherwise be unable to afford.
Let’s look at diversification first:
Mutual funds and stock investors face two kinds of risk. The first is nonmarket risk; risk their portfolio will underperform the market. The second is market risk; risk the market, as a whole, will perform poorly.
Diversification can reduce nonmarket risk, but it has no effect on market risk. Each unit of the fund, purchased by an investor, represents a diverse portfolio of stocks held by the fund. That’s how diversification is achieved through mutual funds.
However, studies show nonmarket risk, through diversification, can be substantially reduced through owning as few as five stocks of companies in substantially different industries. When we invest an equal dollar amount in five stocks, nonmarket risk is only 14% above the minimum that can be achieved through diversification. In the case of ten stocks, nonmarket risk drops to just 7% above the minimum. This means an individual investor does not need to purchase a great many stocks to benefit from diversification. It is quite possible for small and medium investors to cut nonmarket risk without mutual funds.
The results of professional management are mediocre for most funds. As many as 75% of stock funds consistently underperform stock market averages. For this dubious performance, fund holders often pay sales and/or redemption fees and almost always pay management fees. It is very important for investors to watch management fees, in particular, and make sure they’re justified. Here is why.
Studies show that over 25 years, a tax sheltered mutual fund with a 7% annual return and 2.l% annual management fees, will leave only 61% of the accumulated capital for the investor. The remaining 39% goes to the funds company! When you buy stocks directly, there are no management fees.
Former Magellan manager, Peter Lynch, one of the most successful fund managers ever, freely admitted that it is not unusual for individual investors to beat the returns of mutual funds.
Another risk is that your fund may purchase stocks you’d never purchase yourself.
I don’t mean to disparage mutual funds. They definitely have their purposes. But are they always less risky than direct stock purchases? Not necessarily. The term “buyer beware” definitely applies to mutual funds.