Tuesday, January 19, 2010
Straight stock not a good idea for most investors
One day each week, we post a question and answer on the blog. Got a question for us? Post it in the comments section or e-mail it to firstname.lastname@example.org.
QUESTION: I have about $420,000 put away so far for retirement. I’m 45 years old. I’d like to put some of that in stocks to diversify. Right now, it’s divided between four mutual funds. Are there any guidelines for how much money I should invest in straight stocks and how much in some type of secure investment?
ANSWER FROM DAN DANFORD: You may be asking the wrong guy. We manage a number of million-dollar IRA portfolios, and almost always use mutual funds. The key is to use funds with different investment strategies and market sectors to achieve diversification. Done properly, you get the benefits of owning stocks but without the "company-related" risk associated with a particular corporation.
The problem with individual stocks is that each company carries risk that can't be erased. No matter how good the company is - and we can all name dozens of good companies - there's a chance that some event might doom the company. A massive lawsuit, maybe, or some competitive or natural disaster. In brief order, the company can go from stable to bankruptcy. Shareholders can lose it all. Not likely, perhaps, but possible. The only way to reduce this risk is to buy other company stocks. Each additional stock in the portfolio reduces this company-specific risk.
That's where mutual funds come in. Most funds have a rule that no individual stock can comprise over five percent of the portfolio. Hence, they've already achieved a level of diversification beyond what's necessary to reduce the company-specific risk. Picking stocks requires a lot of time and effort, and watching a portfolio of 20 is ridiculous for most amateurs!
It's important to note that other types of risk don't go away with mutual funds. Market risk and Inflation risk and Political risk can still move markets up and down, and mutual funds will move up and down with them (so would individual stocks, for that matter). To reduce (but not eliminate) those risks, carefully choose funds with different investment strategies and market sectors. That should temper some of the fluctuations while preserving the performance potential of stocks.
Mutual fund critics point to the cost as a shortfall of this strategy. And I agree that it can be. Another key part of the strategy is to focus on funds with low internal management fees. There is a direct reverse correlation between the rate of mutual funds fees and their performance for shareholders. Do like we do; choose known funds, with good performance, and low fees. Diversify across sectors and management styles. Watch the mangers you select with care, but not too closely. Over time, your nest egg will grow nicely. At your age, and with this amount of capital, you should have a very nice retirement. If you ever want professional attention, give us a call!