“The art of investment has one characteristic that is not generally appreciated. A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom.” – The Intelligent Investor
Assuming that you want to “invest” in the stock market, and not “trade” or “speculate”, getting average market returns is a no-brainer. One just needs to buy an open-ended index fund or an exchange traded index fund, and one is done. At the lowest cost, one is guaranteed returns that the market index will give – day on day, month on month, year on year.
Why, then, should anyone be even interested in investing in actively managed mutual funds? There can be only a few reasons for that.
First – they give returns better than the index after deducting costs.
Second – One wants an exposure to companies outside the index in a specific market cap or sector or style that one is bullish about. So, in that case, it may make sense to supplement one’s index fund holdings by some actively managed funds that suit these requirements.
After that, why should one directly invest in stocks? Is it worth the time and effort?
“We are quite certain that the funds in the aggregate have served a useful purpose. On a comparative basis, we would hazard a guess that the average individual who put his money exclusively in investment fund shares in the past ten years has fared better than the average person who made his common-stock purchases directly.” – The Intelligent Investor
There are ony few reasons when it may make sense.
First – One is a better investor and can beat markets consistently. Easier said than done, but if that is the case, there is no reason one needs to invest through the fund route. It is likely to take enough time and effort, but if indeed one can beat the index, why depend on mutual funds?
Second – One wants to invest in some businesses that are either small or in under-researched sectors that funds are not allowed to, or not able to invest in. There is a section of the market that institutions are not interested in. An individual investor, who understands those businesses and has conviction on a company, has an advantage by investing directly.
Third – this is perhaps due to the structural constraints of mutual funds. Due to the inherent requirement of funds to keep beating the index, some great businesses cannot be held by funds for long periods of time. For example, a mid-cap fund has identified a great mid-cap company, but once it becomes successful and actually becomes large cap, the fund has to sell it. Or, during a market crash, a fund must sell some companies to honor redemptions – so a buy and hold is not possible, even in case of great businesses.
In such scenarios, it may be worth it for individual investors to invest directly in stocks instead of the mutual fund route. But as index returns are easy to get, one must be sure that these additional investments will actually help better portfolio returns rather than dilute them.
Therefore, overall – allotting majority of your equity allocation to mutual funds (index or active based on performance) might be a prudent strategy for individual investors.
Investments through direct stock holding can be a small part of your equity allocation – only in situations where there are valid reasons for the same.
“To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” – The Intelligent Investor