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.
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