Despite my interest in investing in individual stocks, and the good amount of time I’ve put into securities analysis over the last several years, I actually have a large portion of my holdings in mutual funds. Though I enjoy investing in individual securities, I have, until recently, not been able to devote the time, nor have I had the skills, to invest in individual securities in such a way that I believed would generate risk-adjusted returns above what certain respected professionals are capable of achieving. Though many mutual funds (read: most) are no better or worse than investing in ETFs or even on your own, there are several standouts that have consistently outperformed the market over long periods of time, or that employ sophisticated, unique strategies that even the most educated of investors are likely unable to employ themselves. Before moving posting a follow-up article with my specific mutual fund holdings, I want to illustrate why I believe mutual funds are a crucial part of any do-it-yourself investor’s portfolio, particularly those who have little experience, little time, or little track record of positive, risk-adjusted returns over a long period of time. A monkey can make money in an upmarket, but it is significantly more difficult to outperform the stock market over a full bull/bear cycle.
1) As much as most of us would like to believe in our abilities to outsmart the whole of the population, the fact is that most individual investors do themselves a disservice by taking their finances into their own hands. The market is an extremely complex beast, made more difficult to beat by the fact that inexperienced investors in particular tend to be extremely emotional, and do not have the skills required to thoroughly assess the deserved valuation of a business. I wish I had bookmarked it, but I remember reading a couple years ago a study that was released which estimated that the average individual investor had returns, after transaction fees, of about 2%, vs. 12% for the market. (If anyone knows the article I am referring to, or similar studies, please e-mail me so I can footnote this).
2) If you are like most inexperienced investors, you aren’t investing in the stock market, you are gambling. Investing, in my mind, refers to an investment in the company based on a thorough, in-depth analysis of a company’s business prospects, how those business prospects are likely to translate into future cash flows, and at what multiple those cashflows are likely to be valued in the future. Investors who buy a company because they like their product make the common, deadly mistake of investing in a company, not a stock. Investing in a company has a variety of pitfalls. Most notably, it does not take into account valuation. Let’s examine a hypothetical company, “The Best Company in the World” (TBCW). TBCW makes the highest quality MP3 players imaginable—they are as cool and functional as iPods, but at 1/5th the cost. They use the best materials, and are commited to 100% customer satisfaction. Most people are convinced that TBCW will quickly become the market leader in every consumer goods market imaginable. So, should you invest in TBCW? Not nessecarilly. If TBCW is valued at $100 billion dollars, it is unlikely to be valued at an attractive multiple of its future cash flows. Also, it is entirely possible that TBCW is losing boatloads of money, and will never be profitable. In this case, even though the product is spectacular, the stock will eventually be worth $0. Without the skills to assess valuation and basic finance, investors are gambling, not investing, their money. Just as it would be a poor strategy to go to Vegas and gamble 100% of your money at blackjack, it is similarly wise not to do the same with the stock market.
3) Perhaps the most important reason for putting a significant portion of your money with a professional is most people’s tendency to be extremely emotional with their investments. Countless anecdotes and bear markets have shown that most investors buy most aggressively at market tops, and sell most aggressively at market bottoms. In fact, most top managers have made a living playing the opposite side of the “dumb money flow”. Being able to make intelligent investing decisions requires a clear investment thesis, and a general understanding of valuation concepts and market cycles. If you have a holding that has dropped by 80% on news that you believe does not impact your long-term thesis, you can have the confidence to go ahead and double down. If are holding that same company, and bought it on the recommendation of Jim Cramer, a friend, or another questionably credible source, you have no basis on which to make a future investment decision. Chances are, if you are like most investors, you will panic and sell at the absolute bottom, and curse yourself two years later once the stock rebounds.
4) There are many experienced professionals who have devoted their whole lives to investing. Though there are many irresponsible fund managers out there, it is generally very easy to find several strong, long-term performers that have out-performed the market. What are your odds of outperforming a top manager who has vast resources, experience, and a track record of beating the market over long periods of time? Possible if you know what you are doing (and understand where individual investors with the right skills have an edge over funds), but unlikely if you are merely buying your favorite companies or on the advice of friends. This may work for a short period of time, but just as in Vegas, the house will likely eventually win. One additional point here is that even if you are experienced, you likely are inexperienced in certain types of investing that you want exposure to (e.g. commodities, bonds), or that you simply don’t have access to (emerging markets, foreign stocks, etc.).
5) Most important of all, investing is not a game. For most people, this is retirement money, a kid’s college education, or other important issues. If you want a game, start a play money portfolio on one of the many finance sites out there and try your luck. If you want to gamble, get a night at the Wynn in Vegas and gamble with a few hundred bucks (this will be a much cheaper proposition for most people long term, anyhow).
For the individual investor who does not have the time or experience to devote to their portfolio’s, mutual funds have always been a popular strategy.
So now I’m terrified—five things you can do:
I am not saying that you should not invest in stocks on your own if you have little experience. All I am saying is that you should invest with an amount you can afford to lose, and that if you are serious about investing on your own, you educate yourself on the tools of the trade (this does not mean reading this article and a couple others, this means buying (and reading) investment books, reading reputable sites (especially this one, haha), and honestly assessing your skills on a regular basis. My father is a great example of someone who should be as far removed from his money as possible. Though he is incredibly intelligent, he is very emotional about his money. He successfully timed the 2000 market top, and 2002 market bottom by moving 100% into stocks in 2000, and moving 100% into bonds in 2002. If this sounds like you, find yourself a professional to manage your investments.
When I first started somewhat-intelligently investing several years ago, I limited my allocation of individual stocks to 20% of my portfolio, and put the other 80% with external managers. As I have continued to become educated and confident in my abilities, that number has shifted to about 50/50 (my short positions complicate the actual calculation). Though I may cut this down in the future, I always expect to invest some in mutual funds. There are some incredibly talented investors out there, particularly in areas where I am not myself skilled (e.g. Foreign bonds), that I always expect to outsource to other managers.
Mutual funds are an excellent way to diversify your holdings, and invest alongside some of the more talented investment managers out there. I highly recommend Morningstar as a starting point for your research, and a subscription to get their write-ups. Here are some quick, general guidelines for choosing mutual funds:
1) Examine performance over long-periods of time; 5-10+ years. If the manager has outperformed the market in this time frame, chances are that you are in pretty good hands
2) Make sure the manager in place now was the manager that got those great returns for the prior 10 years. Many top managers have left for hedge funds recently, so make sure the guy who got those returns is still around
3) Examine the funds performance in market downturns. In general, I like to avoid volatility, as I believe investors behave badly when their funds drop a good deal. If you know you are emotional with your investments, you are better off choosing a fund that has consistently deliver 10% returns, vs. one that has delivered 15% returns on average, but with severe downdrafts in bear markets. You are unlikely to achieve those 15% returns that the fund gets, because, if you are like most investors, you are likely to sell that fund near its bottom, and buy it back on the way up. Also, I am personally bearish on the market currently, so in my mind this analysis is more important than usual.
4) If you are confident in your ability to assess the strength of other’s skills, but not to invest in individual securities, I highly recommend reading commentaries or other articles about managers who run funds you are looking at. My two favorite mutual funds, (Hussman & Fairholme), I invested in more because I thought the managers were incredibly smart and disciplined, and less because of their performance (which, unsurprisingly, was also incredibly strong).
5) One major disagreement I have with Morningstar is on the topic of expenses. Morningstar is hesitant to recommend mutual funds with high management expenses, regardless of their performance. I think this is rather silly. Below you will find the 10 year annualized returns of two funds, pre-expenses. Which one would you rather invest in?
Fund A: 10%
Fund B: 15%
Fund B, obviously. Now, lets say Fund A has a .5% management fee, and fund B has a relatively expensive 3% management fee. Which one would you rather invest in now?
Fund A: 10%-.5%=9.5%
Fund B: 15%-3%=12%
Again, the answer is B. Don’t let high funds scare you off—one of the more respected fund families (Hotchkis and Wiley), has deservedly high fees. If you outperform your peers as some funds do, you can afford to charge significantly higher fees and still be a more attractive place for investors to park their money.
Unless you have a strong track record of outperforming the market in both up and down markets, or over a full investment cycle, I think it is a very prudent decision to not put 100% of your money in individual securities. Limiting yourself to 10-20% of your portfolio allows you to experience the joy and excitement of investing (or gambling, if you prefer), while ensuring that your retirement, kids college fund, and other causes are well-served.