Create your own personal mutual fund

One of the best reasons to buy a mutual fund, instead of individual stocks, is that a mutual fund spreads the risk over many companies.  Individual stocks are relatively volatile, but holding many stocks averages out the daily noise, and as the group gets larger it tends to track the overall market.

How many stocks does a mutual fund hold? The smallest number of holdings are in focus funds that carry 20 to, perhaps, 50 positions.  These funds aspire to find real winners and don’t want to be held back by losers.   (Of course, it doesn’t always work out that way.)  Many mutual funds hold a hundred or more investments.  Funds that mimic broad indexes such as the S&P 500 hold (surprise!) 500 positions, and in the extreme, funds mimicking the Wilshire 5000 — the broadest measure of the American market — hold positions in 5000 stocks.

How many stocks are needed to diversify? Putting your retirement nestegg in one stock is risky.  (Just ask former employees of Lucent or Enron.)  Spreading out to two is better, five, ten, fifty holdings reduces risk further.  You start covering broader sectors of the economy: durables, consumer goods, technology, financials, and so forth.  But surely at some point, adding one more stock doesn’t significantly reduce your risk.  What is that magic number?

Morningstar’s on-line training states that the magic number is eighteen.   Surz and Price calculate that it takes sixty stocks to reduce the non-systematic variance (a measure of risk) by 88%.  So the real number is probably somewhere between 20 and 100.

What do you mean by “a personal mutual fund” and what would be the advantage? Well, technically “personal mutual fund” is a bit of an oxymoron, because a mutual fund, by definition, is a fund owned mutually by a group of people.  But, what I meant to suggest is that you could own a large number of stocks directly, instead of through a mutual fund.  I can think of a few advantages to the DIY approach:

• You don’t have to pay the fund’s expense ratio, which can range from 0.09% for the least expensive index fund to more than 1.5% for many managed mutual funds.  If you have $100,000 invested, expense ratios take $90-1,500 out of your pocket — each year.  Multiply by ten years or more, and that’ll pay for a lot of margaritas on your retirement beach.
• You can control how the capital gains are realized.  Mutual funds are required to distribute capital gains each year, which can lead to a nasty taxable surprise each December.
• You can take advantage of the larger tax deductions for charitable donations of appreciated stocks.  Since mutual funds distribute capital gains annually, your basis continues to rise.  When you donate shares of a mutual fund your basis is almost equal to the book value.  If you instead donate a stock that has appreciated 10x (lucky you), you can deduct the full 10x value, and never have to pay tax on the 9x gain.

Of course there are also some disadvantages, including:

• A large number of transactions to track.  Tax time could be really taxing.
• You have to pay commissions for each purchase and sale.

Wouldn’t it be expensive to pay for each purchase and sale? Back in the three-martini-lunch days, you bought stocks through a broker who charged you about $75 for the transaction.  Owning 100 stocks would cost $7,500 in commissions, so if you wanted to keep your expenses below 1%, you would have to be investing north of $750,000.  If you had that kind of dough, you likely wouldn’t want to bother with all those piddly transactions.

Then Charles Schwab broke from the pack and, along with other discount brokerages, by the 1980′s you could make the same transaction for about $20.  That lowered your required bankroll to about $200,000.

Recently, however, the cost of equity trades has fallen through the floor, making possible the once unthinkable (if still daunting) possibility of creating a large portfolio.

Reduced trading costs. Last Fall, Schwab lowered the price of equity trades from $12 to $8.95.  Fidelity countered in February, by offering equity trades for $7.95.  This month, Vanguard followed suit by lowering equity commissions, too.  However, Vanguard has retained a tiered system.  Investors with more than $500,000 with Vanguard will now pay the low, low price of $2 to buy or sell a stock.  Less flush investors will have to fork over $7.

At $2 per transaction, it is now conceivable to create a 100 stock portfolio with effectively a 1% expense ratio, even if you have only $20,000 to invest.  (Ok, you’ll need to have $480,000 in other securities to qualify for Vanguard’s low rate.)   There’s every reason to believe that transaction costs will continue to decline.  What if they went to $0?  Would your trading behavior change?

Race to the bottom for ETF commissions, too. Schwab and Vanguard have also eliminated commissions on the sale of their own ETF’s, and Fidelity has done the same for 25 of iShare’s popular ETF’s.

Are low transaction fees really a game-changer? Potentially.  I’m not really suggesting that you give up on mutual funds and shift to individual stocks.  Personally, I find the idea of picking 100 stocks rather daunting.  Of course you could just buy the the 500 stocks of the S&P 500.  But with index funds and ETF’s that already do that for cheap, would the advantages really outweigh the hassles?   Perhaps it could make sense to run a “focus fund” with a small percentage of your portfolio, leaving the majority to quality index funds.  Would it be fun or a bother?  I think the answer to that question is less about the transaction cost and more about your personality and preferences.

Disclaimer: This information is for educational purposes only.  If you have questions about your particular situation, please see a financial professional.

Disclosure: No investments in any companies mentioned.

Image Credit: aloha orangeneko at Flickr

Carnivals: This post was included in this week’s Carnival of Personal Finance hosted at Money Relationship.

Tags: diversification, Fidelity, low cost stock transactions, mutual funds, Schwab, Vanguard