Financial Methods: Individual Investors Have the Edge

Individual investors have significant advantage over the professional investor, specifically, the mutual fund manager. Individuals enjoy the latitude to invest in a wider range of investments, have a lower cost of ownership, and are less likely to be overdiversified.

Freedom

Mutual funds are focused investment vehicles. This does not mean that they are not diversified; they are diversified, and they are also focused. Let me explain.

There is a fund for almost any focus, but they all have one. For example, growth is often a focus - where fund managers try to identify and invest in growing companies. Other funds focus on international companies, others on value, or income, or a combination of styles. Some funds are limited to only large companies, others to middle or small.

Very few funds have the freedom to invest in large US equities for a few years, then move into small international bonds as market conditions change. Mutual funds are typically tied to a particular style and their goal is to perform slightly better than a carefully selected index that matches the style of the fund.

Individual investors are free from this requirement. They can make their selection of asset class based on market conditions and their own risk tolerance. They can buy what's on sale. And they can do it at much lower cost than mutual funds.

Lower Cost of Ownership

Mutual funds are unnecessarily expensive. The cost of ownership of a mutual fund portfolio is usually 1%-2% or more per year. So a $50,000 portfolio at just a 1% mutual fund fee is paying $500 every year. A no-fee brokerage account with infrequent trading would pay significantly less in expenses. Six trades per year at an expensive $50 per transaction would amount to a 0.6% fee. A discount broker would charge much less. And investors control their own expenses in that they decide how often they change positions.

Low turnover is key to controlling expenses. Each sale or purchase within the fund incurs broker's commission charges. Often, mutual fund managers forget this as they trade their way to fund turnover in excess of 100%. Investors in these funds are essentially paying the fund managers to day-trade with their money (and the investors get stuck with the commission charges).

Diversify Less

Not only are mutual funds more expensive than they should be, they are also more diversified than they should be. Diversification is dilutive. Diversification dilutes risk and return equally. As a result, many investors (especially younger investors) have too much diversification. They have been told that diversification is always good. Diversification is great way to keep wealth; it is not a great way to build wealth. To build wealth, less diversification and more risk, is sometimes more suitable.

For most investors, holding stocks in 20 to 40 companies from various industries and regions is sufficiently diversified. It is estimated that the average U.S. equity fund holds about 150 stocks. Investors often hold 5 or more mutual funds. As a result they are likely overdiversified by an order of magnitude.