A while back on our Mutual Funds discussion board, Fool Community member Josephus2 made the provocative suggestion that mutual funds are "riskier than stocks." I think his post offers a terrific opportunity to explore some interesting issues regarding mutual funds.
Here's how he explained his position:
1. Stops are not available on mutual funds:
As millions of investors realized when the internet bubble popped, mutual funds can lose you money just as quickly as individual stocks. Without stop-losses in place, you are risking unlimited losses. (Or at least down to zero)
2. Options are not available on mutual funds:
Buying protective Puts can insure a stock investment against loss. This strategy is especially valuable during earnings season when good stocks are destroyed by the market for no good reason. What is your downside insurance with a mutual fund? There is none.
He went on to recommend General Electric
First off, I don't think it's necessarily so relevant that "stops are not available on mutual funds." With stocks, you can place a stop order with your brokerage to sell your shares if they reach or pass a certain price level. This can help you avoid riding your stock all the way down a steep drop, but it can also kick you out of a good stock if it temporarily slumps, but subsequently recovers.
With mutual funds, as with stocks, many of us investors buy with the intention of holding for the long haul, which can mean years. We tend to expect some volatility, and as long as we maintain confidence in our selections, we ride out downturns. When this is the case, stop orders don't always seem so attractive.
Funds are also often significantly less volatile than stocks. A stock is tied to the fortunes of just one company, after all, whereas a stock fund often holds the securities of scores, if not hundreds, of companies.
Similarly, I don't see a need to protect an investment in a mutual fund with options. Options cost money, for one thing, so you'd be offsetting any gain by the cost of the option. Community member Josephus2 asked, "What is your downside insurance with a mutual fund?" To this, I answer that my downside insurance is the fund's management, which features savvier investors than I.
Finding the right funds
Like Shannon Zimmerman, who heads up our very successful Champion Funds newsletter service, I look for mutual fund managers I believe in, ideally ones who make their investment strategies and thinking clear to investors and would-be investors. For example, I like Bill Miller of the Legg Mason fund family -- I've read a lot of his writings, and I admire his philosophies and track record. His Legg Mason Opportunity (LMOPX) fund, for example, has gained an annual average of 14.5% over the past five years and 12.5% over the past three years. Its concentrated portfolio includes Red Hat
Of course, I wasn't the only one to take issue with Josephus2's thoughts. Here is a sample of the many responses he got. (You can read them all for yourself, too.)
- Joelxwil asked: "Have you looked at a chart of GE recently? Over the last three years it has underperformed the S&P 500, which has not done particularly well either."
- FeedmeNOWhuman astutely added, in response to the idea that funds can drop to zero in value: "The day my Target Retirement fund is worth zero, I'll bet GE isn't so hot, either!"
- Littlechap offered a very detailed and thoughtful response. Here's just a tiny snippet: "Buying put options, while holding a long position in a stock, is a complicated way of hedging your investments that only works if you are really good at it. By contrast, the way a person hedges in a mutual fund portfolio is, as I said earlier, by diversification. Own some other asset class that zigs whenever stocks zag. Own one fund that has interest-rate-sensitive stocks, and another fund with stocks that are impervious to interest rates. Simply look for the biggest variables that might push the overall market in one direction or another, and own positions on both sides of the divide. Heck, one should do that with a stock portfolio, too."
He also noted that Berkshire Hathaway
KennyO added: "Funds move down more slowly than individual stocks [because of] the averaging effect of multiple holdings, and they move up more slowly as well. Hedging [via options] is appropriate to things more likely to be subject to sudden, large moves."
I encourage you to check out the entire discussion. It offers some good food for thought, an interesting debate as Josephus2 responds, and a few chuckles.
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Longtime Fool contributor Selena Maranjian owns shares of General Electric and Berkshire Hathaway, which is an Inside Value recommendation. For more about Selena, view her bio and her profile. The Motley Fool is Fools writing for Fools.