The First Step to Achieving Financial Freedom
One of the most common questions I receive is “Should I invest in individual securities or a fund/ETF?”
I’m a believer in buying individual stocks and bonds, but for investors who don’t have the time or desire to research individual opportunities, exchange-traded funds (ETFs) and other funds are a decent – but often not amazing – alternative.
Many passively managed funds are tied to broad indexes. As a result, they will never outperform those indexes. But because the market goes up over the long term, investing in index funds is a safe, “set it and forget it” strategy. So if that’s what you prefer, index funds are one method you could use.
Most of the time, I don’t recommend investing in actively managed mutual funds or ETFs. They have a long history of underperforming their indexes. For example, if you’re interested in a biotech fund, stick with one that invests according to a biotech index, not one that’s run by a fund manager who’s trying to pick winners by “trusting their gut.”
According to the most recent data, over the past three years, 66% of mutual funds failed to beat their benchmark index. (Maybe you’ll get lucky and pick the 1 out of 3 that does, but the odds aren’t in your favor.)
Furthermore, you pay fees for that underperformance. In fact, the fees can be a reason for the underperformance. If you’re paying a mutual fund 1.5% per year, you’re starting out 1.5% behind the index.
Index funds and ETFs typically have very low fees, which is another reason to stick with them if you do choose to invest in some kind of fund.
But as I said, I believe owning individual stocks and bonds is the way to go.
You pay no fees for buying and selling stocks at most brokers. And with bonds, the fee is priced in. So if you want to buy a bond that’s quoted at $99, that’s what you’ll pay. Most brokers will not charge an additional fee, though there are exceptions, so be sure you understand what commissions your broker charges.
The main reason I prefer individual stocks and bonds to funds and ETFs is you have more control. If a stock is going against you, your stop can get you out before you suffer a big loss, and the decision to sell doesn’t involve any emotion.
But with an index fund, that stock will stay in the portfolio as long as it remains in the corresponding index. And with an actively managed fund, a Wharton-trained fund manager may believe they know more than the market and ride the stock down further – or worse, throw good money after bad.
When you own stocks, you can also take profits when it’s appropriate, whereas with a fund, you have no control or say over what the fund manager does.
I feel even more strongly about holding individual bonds than I do about holding individual stocks. There are some exceptions, such as a closed-end fund trading at a steep discount or an ETF that invests in convertible bonds, but these can be tough for individual investors to find.
For the most part, when it comes to regular corporate and government bonds, you should own them individually. That way, you can decide what maturities make sense for you and you will know exactly how much cash you’ll have available on the maturity dates.
(Bonds have become quite popular right now, and rightfully so. I recently told George Rayburn, our longtime event host here at The Oxford Club, that no matter what the Federal Reserve does next, it’ll be good for bondholders.)
With a bond fund, however, there is no maturity date and your capital is at the mercy of the markets. You may think investing in a bond fund is safe and conservative, but if rates spike, you’ll lose money. And if you withdraw your cash during a period of higher interest rates, you’re going to end up with less than you started with.
That’s the opposite of what we want to see when we invest in bonds.
We invest in bonds for safety. We know we’ll get our money back at maturity – or make a capital gain – because we know the bonds will mature at par value ($1,000) no matter which way the bond market or interest rates move. We’ll get $1,000 per bond at maturity regardless of whether we invested $1,000, $900 or $1,050.
Funds and ETFs serve their purpose, mostly for investors who don’t want to (or are afraid to) make their own investment decisions. But investors who feel comfortable making their own choices and investing in individual stocks and bonds are likely to be better off in the long run – as long as they don’t overtrade and don’t try to time the market.
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