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The Independent Investor: Stocks & Mutual Funds Versus Index Fund

Bill Schmick

On a daily basis, I review portfolios of stocks and mutual funds from clients and readers. What strikes me most about all these portfolios is that I rarely come across one that has done better than the market. A large part of the problem lies in their choice of investments.

When I say "the market," normally I use the S&P 500 Index as a benchmark. Sure, there are other indexes I can use, ranging from the Dow Jones Industrial Average to a basketful of regional and global indexes, but most pros use the S&P 500 as the market proxy. The truth is that it is notoriously difficult to beat the market and do so consistently.

"But what about Apple?" protests one recent client, who has owned this darling of Wall Street for several years. "It has beaten the market hands down every year."

True enough, Apple, along with a number of other individual stocks, have done better than the market for a year or two or even three, but they have not done so consistently year after year. And even though Apple has done better than the market, I have yet to see any equity portfolio with just that one investment. Normally, Apple is just one of many investments in the portfolio. When all these returns are combined, the gains of an Apple are offset by losses in other stocks.

The risk in holding individual stocks is twofold. One, if you hold comparatively few stocks and one or more blows up, your portfolio will suffer dramatically. If, on the other hand, you have a large stock portfolio it becomes difficult to follow and your performance will tend to mimic the market.

Investing in mutual funds is less risky than owning individual stocks because your risk is spread out among many more stocks; but unfortunately, in most cases, performance also declines. Statistically, the pros that manage mutual funds fail to beat the market over 80 percent of the time. If you also add the fees that these mutual funds charge investors each year their performance is even worse.

Now, just like stocks, there are mutual funds that have a fabulous track record, either because the fund manager is especially gifted, lucky or both. Think Peter Lynch, the fabled manager of Fidelity's Magellan Fund, or Bruce Berkowitz, recently named the fund manager of the decade. But finding the next Peter Lynch is as difficult as finding the next stock market double.  In the meantime, the risk of picking wrong can be monumental.

Ken Hebner, a well-known index fund manager, argues that by buying a diversified portfolio of index funds, that incorporate emerging markets, international markets as well as the U.S. market, will provide you the best results with lower risks than a portfolio of stocks. I would take that a step further.

My experience indicates that by including certain sector index funds in your portfolio (while excluding others) you could generate even greater gains than the market. For example, during the first quarter of this year, the materials, energy and small cap sectors lead the market higher. Those investors that were overweighted in these areas beat the market with much less risk than if they had held individual stocks in those sectors. In addition, the expense ratios for index funds are much cheaper than mutual funds. Bottom line, index funds offer far less risk than stocks, outperform mutual funds 80 percent of the time and are cheaper, easier and trade as frequently as stocks. What's not to like?

Bill Schmick is registered as an investment adviser representative and portfolio manager with Berkshire Money Management (BMM), managing over $200 million for investors in the Berkshires. Bill's forecasts and opinions are purely his own and do not necessarily represent the views of BMM. None of his commentary is or should be considered investment advice. Anyone seeking individualized investment advice should contact a qualified investment adviser. None of the information presented in this article is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com. Visit www.afewdollarsmore.com for more of Bill's insights. Any references to specific securities are for illustrative purposes only and were selected based on a nonperformance-based criteria. The performance of the securities listed is not discussed and Berkshire maintains a listing of all recommendations for the preceding year and makes it available to the SEC upon request. The securities identified and described do not represent all of the securities purchased, sold, or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable. While Bill Schmick or BMM may invest or has invested with the managers mentioned in this article, the article itself should not be construed as a solicitation to invest or an endorsement of a particular investment. You should carefully evaluate all investment options with your financial adviser. Neither Bill Schmick nor BMM endorse or independently verify any data or opinions expressed by a third-party.


Tags: securities, portfolio      

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