Invest Like a Philosopher: Stocks vs. Mutual Funds

"In character, in manner, in style, in all things, the supreme excellence is simplicity."  -- Henry Wadsworth Longfellow (1807-1882)

When it comes to investing, our human nature tends to fool us into believing that we are intelligent enough to "beat the market" with savvy stock selection, thereby making investment decisions much more complex than they need to be.  After all, thanks to the internet, we have easy, quick, and detailed access to more information than ever in our history.  Why wouldn't an investor expect to derive higher performance in return for their "advanced" research or their new-found "strategy" that no one else knows?   For the vast majority of investors, the answer to that question is three words:  Efficient Market Hypothesis (EMH).

EMH says that all of the information known about a publicly traded company is already priced into the stock.  Why is that a problem?  The answer is quite logical and simple:  If information is so readily available, then the only real edge an investor can gain from their research is by finding the information before other investors or by selecting asset types or sectors ahead of their respective market dominance, all of which are nearly impossible on a consistent basis or illegal (inside information) to achieve.  Furthermore, the future performance of a stock is unknowable, so throwing darts at a wall could produce the same (or better) results with almost no effort.  Arguably, "luck" has produced greater returns for investors than "skills," especially over short periods of time.   

This misjudgment on the part of investors is especially prominent with large-cap stock investment.  Almost every portfolio I have reviewed for a prospective client looks almost identical:  Whether it is a "self-managed" portfolio or one managed by a traditional stock broker, the portfolio typically consists of about 20 stocks, either all or nearly all of which are large-cap stocks found in the S&P 500 index (think Exxon/Mobil, Pfizer, Bank of America, Microsoft, etc).  Large company financial information is the most readily available in the universe of publicly-traded companies.  My five-year old son could pull up Wal-Mart's 2006 financial statements on Yahoo Finance within seconds.  It would take me another five minutes or so to show him how to determine its "value" as a stock purchase.  With information so easily attainable, by what means do we have as investors to gain an advantage over everyone else? 

In keeping with our philosophical theme of simplicity for this post, let's follow a short path of logic, and a bit of the Socratic Model, to arrive at our "stocks vs. mutual funds" evaluation:

• Most would agree that a diversified portfolio of stocks would contain 20 or more holdings.  In essence, you are creating your own "fund."  Is that not what mutual fund managers do for a living?  If you are selecting your own stocks for a portfolio, are you assuming you have the time, resources, and knowledge to research the balance sheets of companies to find those "hidden gems" that everyone else and their brother (or five-year old son) has already poured over?  In selecting your own stocks are you assuming you can do a better job than "professional" money managers, who have been doing it for a living for years, can do?
• The biggest stock selection mistakes I see are not only from "non-professional" money managers but of traditional stock brokers:  A portfolio of mostly large-cap stocks found in the S&P 500 is not truly a diversified portfolio.  This creates higher market risk than a broadly diversified mix that might include less efficient small caps, mid caps, and foreign stocks. 
• The odds are stacked against even the most intelligent money managers to consistently out-perform the S&P 500 over time, especially long periods.
• According to Morningstar,  a good S&P 500 Index fund, such as Vanguard 500 Index or Fidelity Spartan 500 Index, out-performed more than 75% of all other "large blend" funds (which includes "actively managed" funds) last year.  One caveat:  The year, 2006, happened to be a good year for index funds because most managers missed their sector bets. 
• For the last 15 years as of December 31, 2006, the Vanguard 500 Index fund beat 68% of its large blend peers.  How many "non-professionally managed" portfolios do you think the S&P 500 beat over that time frame?
• The best performing S&P 500 stock in 2006, Allegheny Technologies (ATI), put in a 151.3% gain.  Did your "research" tell you to by that stock?  Have you even heard of ATI?  The worst performing stock for the S&P in 2006 was Whole Foods Market (WFMI), which dropped 39.4%.  The S&P 500 Index, as a whole, was up 15.79%.  Can you consistently pick the winners and avoid the losers?

To keep this post a digestible length, this lesson is three-fold: 

1. A philosopher (or any person wishing to be wise) will either select a prudent manager of their portfolio or manage it themselves in a simple way.  Historic odds tells us that the energy placed into "beating the market" is only self-defeating, especially with large-cap stocks.

2. The markets are too efficient in the large-cap area; therefore, you will not be sufficiently rewarded for your diligent research when the information you are seeking is already widely known and already priced into the stocks you are buying.

3. Use index funds or widely traded ETFs for the large-cap portion of your portfolio (more info on the use of ETS as well as sectors in following posts).  For less efficient areas of the market (small-cap stocks, foreign stocks), do not use index funds or ETFs:  Use "actively-managed" funds with at least a three-year track record and an established fund manager.

If you have not guessed by now, a philosopher, aware of his or her own ignorance, would leverage the knowledge of others by using mutual funds over individual equities.  A philosopher would also use index funds or ETFs over "actively managed" funds for large-cap stocks and actively-managed funds over index funds and ETFs in all other areas. 

Stay tuned for "Index Funds vs. ETFs..."

 

TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a fee-only, registered investment adviser based in Mount Pleasant, SC, near Charleston.  ACI specializes in retirement, investments, and comprehensive financial planning.