A discussion about personal finances can be a polite, congenial affair. Few people come to blows over insurance or budgeting. But some topics inflame financial passions, and one of them is stock market investing. Fellow Get Rich Slowly e-scribe William Cowie encountered this a couple of weeks ago when he advocated for investing in individual stocks in certain situations. I thought I would pass along a few thoughts of my own, given that 1) William cited the success he's had with a newsletter from The Motley Fool (my employer for the past 15-plus years), and 2) my own portfolio has big holdings in index funds but also some actively managed funds and individual stocks.
This is a huge topic, with enough books written about the subject to fill a library. But for today's post, I'll question one of the main arguments against individual stocks. And as my posts have traditionally been sprinkled with cat pictures, I'm including this cool "peace" cat as inspiration.
People are not actively managed funds
The evidence is clear: Most actively managed funds underperform similarly invested index funds. The Standard & Poor's Index vs. Active (SPIVA) mid-2014 report says that more than 70% of actively managed funds lost to their respective benchmarks over the previous five years. The cheerleaders of index funds have plenty of hard evidence to power their pom-poms.
This leads some to argue that if fancy-pants Wall Street fund managers can't beat an index fund, then the average Josephine doesn't have a chance. However, fund managers have to overcome hurdles that individual investors don't.
First off, fund companies take money from your account to pay for running the business and buying fancy pants. The fees charged by index funds are much lower than those charged by actively managed funds, which gives the former group a head start, performance-wise. According to the SPIVA report, the S&P 1500 index (a more comprehensive measure of the U.S. stock market than the S&P 500) earned an annualized 19.2% over the five years ending June 30, 2014; the average actively managed fund made 18% percent -- a difference of 1.2%. Not coincidentally, that is just about the average fund's expense ratio -- i.e., the percentage of your account value a fund company extracts. In other words, higher costs are one of main the reasons active funds lag index funds.
Investors in individual stocks, on the other hand, simply pay commissions, which are generally $10 a trade or less. If those shareholders are true buy-and-hold investors -- which is the right way to do it -- then that is the only expense they will pay to own a stock for years to come. To be fair, investors who subscribe to research services should also factor in those costs. But annual expenses for investors in individual stocks shouldn't be anywhere near 1%.
Also, fund managers must deal with the flow of money in and out of the fund, which might force them to invest in ways they would rather not. For example, when the market tanks, fund investors collectively take out more money than they put in. This can force managers to sell stocks after prices have already plummeted, even though they would prefer to be buying when stocks are down. On the flip side, when the market or a particular fund does well, money pours in, and the manager is compelled to invest the cash after prices have already gone up. As a fund gets bigger, its menu of potential purchases shrinks: It can no longer invest in smaller companies because buying a meaningful stake could drive up the price.
Individual investors don't have these concerns. They can invest in small and big companies alike as well as buy, sell, or hold based on their own circumstances and choices. They are not forced into selling because others are panicking.
Do these advantages that individuals have over fund managers lead to market-beating returns? The research is not as extensive as the "index versus active funds" literature -- and much of it is outdated, involves only a few years' worth of investing, and/or is based on data from foreign exchanges. But I know of enough people who have pulled off benchmark-beating returns to know that it is possible.
Indexing and picking stocks, living in harmony
There is so much more to say on this, but for now, let me pass along these three thoughts.
1. Index funds are the right choice for most investors' money. Even Warren Buffett, one of the greatest investors of all time, agrees. In the 2013 annual letter to Berkshire Hathaway shareholders, he revealed the instructions in his will for the money his wife will inherit. "My advice to the trustee," he wrote, "could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.)"
2. This isn't an either/or decision. Even some of the most ardent supporters of index investing are OK with people having 5% to 10% of their portfolios in individual stocks. One of those people is Bill Schultheis, author of The Coffeehouse Investor (one of my all-time favorites). He wrote: "Somewhere among the millions and millions of stock pickers you might be the next Warren Buffett. But I am not sure it is worth risking your entire portfolio to find out you aren't."
Many people who are known for their indexing advocacy own some individual stocks on the side. Heck, even Vanguard -- the company most known for advancing the cause of index funds -- has been offering actively managed funds for decades. Last year they published "The Case for Vanguard Active Management" and launched their non-indexy Global Minimum Volatility Fund. If Vanguard can be cool with an investor having both active and indexing strategies in a portfolio, then it's probably fine.
3. Keep score. However you invest, evaluate your choices annually. Are your actively managed funds keeping up? Do you have the best index funds? If you have a financial advisor, how is she doing? If you are picking stocks, how are you doing? If you're not sure how to do all that, have no fear. It will be the topic of one of my first posts of 2015. But beating an index fund is not an easy thing to do, so it's important to know sooner rather than later whether your forays into active management are paying off.
Robert is a Certified Financial Planner and the advisor for The Motley Fool's Rule Your Retirement service.
This article was originally published on Get Rich Slowly.
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