Average investors have two avenues for investing in various markets: do it themselves, or have someone else do it for them. The Self-Investors will open a brokerage account and buy individual securities. The “hire-a-manager” crowd will either hire a professional portfolio manager, usually a brokerage firm, or invest their assets in funds.
While there is steadily growing interest in Electronically Traded Funds (ETF’s), mutual funds are still the most popular funds for investment. So, which method should the average person use to invest his/her assets? There are a number of considerations when choosing how to invest in the markets.
Portfolio Management
This is the primary issue for most investors. Self-Investors need to research and select the securities to be purchased. Most average investors do not have sufficient knowledge, experience, and discipline necessary to construct and maintain a portfolio of individual securities.
Mutual Funds are professionally managed by teams of experienced investment managers. These managers invest according to the stated objectives of the fund and use disciplined approaches to selecting securities.
Diversification
An investor should never put all assets in one investment. Assets need to be diversified among asset classes (stocks, bonds, commodities, etc.). The reason is that markets are unpredictable and asset classes do not perform in tandem every day. Spreading assets among asset classes will smooth the risk exposure to any one asset class. Assets also need to be diversified within each asset class, which entails buying a number of different securities.
Self-Investors would need to buy over 30 securities to attain the necessary diversification among classes and within classes. This might be made up of 17 stocks, 7 bonds, 3 commodity stocks, and 3 real estate stocks.
Mutual Funds provide instant diversification within asset classes. The average large company stock fund holds 125 stocks. Investors using funds should only need to buy 2-3 stock funds, 2-3 bond funds, 1-2 commodity funds, and 2-3 real estate funds to achieve necessary diversification. All of these funds are offered by most mutual fund companies.
Economies of Scale
If a Self-Investor only has $5,000 to invest, it is difficult to buy the number of securities necessary to achieve proper diversification. These investors will be forced to either focus on cheaper securities, which is not the way to invest, or buy fewer shares of each security, such as 20 shares of a stock.
Mutual Funds combine the assets of all investors and purchase shares in bulk. The manager has the ability to purchase all desired securities in large quantities. This, in turn, lowers transaction costs.
Cost of Investments
Self-Investors adding money to, or withdrawing money from, their accounts would need to purchase or sell securities. Each transaction carries a commission cost. There are no management costs since the investor is the portfolio manager.
Mutual Funds allow investors to add new money into the fund at any time at no cost. The same applies to withdrawals, with possible restrictions on certain funds. Professional management comes at a cost. Annual fund management fees will vary between .5% – 2% of assets. While this may appear high, it is a small price to pay to have a professional manage your assets.
Conclusion
Mutual Funds are definitely the better investment choice for average investors. Professional management, diversification, ease of access, and economy of scale cannot be matched by Self-Investing. Investing is hard enough and going it alone will cause many sleepless nights.