Single-Stock Exposure’s Burn Risk Is High
One of the best reasons for investing in mutual funds rather than individual stocks can be expressed in two words: Philip Morris.
Or three letters: IBM.
These, after all, are components of the mighty Dow Jones industrial average. They’re among the most widely followed, most thoroughly researched companies in the world.
They’re not the type of stocks supposed to fall 25% in one day, as Philip Morris did on April 2, or 43% over the course of a year, as happened to IBM in 1992.
In fact, six of the 30 Dow stocks tumbled 11% or more in 1992, one of the least volatile years on record. The average general-equity fund, by contrast, rose nearly 9% over the same period.
If blue chips sometimes crash and burn, can you imagine the devastation possible with an up-and-coming technology stock that gets into trouble?
If you can’t, consider what happened to Synergen Inc. Shares of the biotechnology company lost 83% of their value during the first quarter, when test results for a promising new drug didn’t turn out as well as hoped.
People have been flocking to mutual funds instead of individual stocks for two reasons. Diversification is the first, and the second is a feeling that the average guy or gal can’t compete in the marketplace with institutional investors.
Plenty of pros--including some mutual fund managers--also got burned by Philip Morris, but at least they could have started to react minutes after the company announced that profits on its tobacco operations would be off 40%.
How many individuals sit around watching the ticker tape and the news wires during the trading day? “Most people aren’t involved all day long in the investment markets and are focused on other things, so they’re really at a disadvantage,” says Dalton Sim, chief investment officer of the INVESCO Funds Group of Denver.
“In this business, managers generally work 10- to 12-hour days, and they have a tendency to carry their briefcases home to put in further time.”
The diversification angle also gives mutual funds an edge. Although Philip Morris and IBM have been favored holdings of many portfolio managers, few funds had more than 2% or 3% of their assets in either stock when they fell, and most had less.
All mutual funds provide at least some diversification. Portfolios range from several hundred stocks to a couple of dozen or so. (Some might have less if the manager is riding out a storm with a heavy cash weighting.)
“Various studies have shown that you can get adequate diversification with 12 to 16 stocks, provided they’re spread among different industry groups and are apportioned fairly equally in the portfolio,” says Charles B. Carlson, editor of the Dow Theory Forecasts newsletter in Hammond, Ind.
So-called sector mutual funds, which invest in specific industries ranging from telecommunications to gold mining to oil, hold at least that many stocks but wouldn’t meet a true diversification definition because of their narrow concentrations.
A fund’s prospectus will tell whether a particular portfolio meets the formal diversification guidelines laid down by the Securities and Exchange Commission. Most funds do.
In all fairness, investors willing to put in the time and make the effort can do well with their own portfolios of individual stocks. A do-it-yourself approach allows people to concentrate their holdings in companies they feel strongly about or know intimately. They can also save on annual operating expenses, which all mutual funds charge. These range from about 0.5% to 2% a year, with 1.3% the norm among growth portfolios.
Carlson, the author of a book on dividend-reinvestment plans, recommends the plans as a low-cost way for long-term investors to accumulate shares in favored companies over time.
More than 900 stocks and closed-end funds offer dividend reinvestment, providing a way to purchase small amounts of shares gradually without paying brokerage commissions--after making the initial purchase through a broker. Mutual funds, of course, also offer no-cost dividend reinvesting and many allow investors to make small subsequent purchases of $100, $50 or less.
Many more funds provide these services than individual stocks do. In fact, some groups will let you reinvest the dividends generated by one fund into another--a low-risk way to move gradually from, say, a bond portfolio into a stock fund.
With either funds or individual stocks, a big benefit to making incremental investments over time is that you accumulate shares in small amounts and at various prices. This means you don’t need to worry about putting all your marbles into play at what could be a market peak.
Another characteristic of an “averaging” strategy is that you will tend to purchase more shares when prices are low and fewer when they’re high. But an averaging strategy typically works better with mutual funds than individual stocks because of diversification. A well-rounded fund may bob up and down, but it will tend to follow the broad market higher over time. There’s no such assurance with an individual stock--even a blue chip--which might go down for the count and never get back up.
Funds With a Focus
There’s something to be said for not diversifying too much. If you feel you can cherry-pick the best companies in the stock market, why would you want to dilute your holdings with mediocre selections?
The following mutual funds adhere to this type of reasoning, preferring to concentrate on just two to three dozen stocks. Most of the funds are smaller, and each enjoys a superior rating from Morningstar Inc. of Chicago.
Average Minimum yearly Fund Name/Category Load Phone investment return ABT Emerging Growth/Aggressive 4.75% growth maximum 800-553-7838 $1,000 +27.3% Clipper Fund/Growth & income None 800-776-5033 $5,000 +16.9% Lexington Corporate Leaders/Growth & Income None 800-526-0056 $1,000 +12.4% Northeast Investors Growth/Growth None 800-225-6704 $1,000 +14.0% L. Roy Papp Stock/Growth None 800-421-4004 $10,000 +16.7% Sound Shore/Growth None 800-551-1980 $10,000 +15.5%
Notes: Average annual returns are for three-year period ending March 31, 1993. Some of the above funds have lower minimum investments for money placed in individual retirement accounts.
