Consider individual risk, performance in choosing

Individual investors have overwhelmingly leaned toward mutual funds in recent years as their way of participating in the stock market.

But in the wake of increasingly low online trading costs and lower capital gains tax rates, some experts are arguing that investors should seriously consider investing in individual stocks.

Which is right for you? Or should you do both? As with any investing question, the answer depends on your individual circumstances. Here are some key points to consider.

Dollar amount of your portfolio. Regardless of the other factors, if you don't have much money with which to invest, mutual funds are the only practical way to construct a well-diversified portfolio. You may need to buy at least a dozen very different stocks (some experts advocate 50 stocks or more) to diversify adequately, but buying that many stocks takes some dollars.

Diversified mutual funds often own 100 or more stocks and minimum investment amounts are reasonable. Another option is to invest in the growing number of mutual funds that concentrate on only 12 to 15 stocks.

Desire and time. Do you have the time and the interest to research all those individual stocks? The Internet makes it much easier for investors to dig up information on stocks than it once was, but it's still a lot of work. Although there are thousands of stock mutual funds, it's usually easier to narrow down funds than individual stocks.

Dollar cost averaging. If you invest regularly each month particularly small amounts, such as $25 or $100 mutual funds are probably the way to go. However, some companies allow you to buy their stock directly from them and to buy additional shares each month, along with reinvesting your dividends.

Performance and risk. There's no question that an individual stock can far outperform a mutual fund's return, simply because a fund brings its return down by owning so many stocks.

Of course, that's one of the benefits of a fund compared with owning a stock less volatility than individual stocks. One stinker in a small portfolio of individual stocks can really drag down overall performance.

Expenses. With online trading costs dropping to around $10 and trades through discount brokers around $20, the impact of the single most expensive aspect of trading individual stocks transaction costs is being dramatically lessened. At the same time, the expense ratios for some stock mutual funds the portion of your investment that annually goes to transactions, marketing, administration, etc. have risen.

Investment experts caution, however, not to let low online trading costs tempt you into trading too often. They feel you're better off over the long term if you buy and hold instead of trying to time the market.

Control. Lower capital gains rates (20 percent maximum if the investment is held at least 18 months) make it more advantageous to hold on to stocks longer, particularly the higher your income-tax bracket. With individual stocks, you can take your gains and losses when you want to.

Short of simply selling your fund shares, you can't control when your mutual fund buys or sells stocks (a high portfolio turnover means more short-term capital gains subject to ordinary income taxes). Keep in mind that some mutual funds, especially index funds and value-oriented large-cap funds, hold on to stocks longer, lowering the tax impact.

International investing. Many certified financial planners recommend that some portion of most portfolios (say, 5 percent to 25 percent) be invested overseas. However, picking and buying foreign stocks is much too difficult a task for most individual investors. It's far easier to buy into one or more foreign mutual funds.

Instead of choosing either/or, you may want to consider having part of your portfolio in mutual funds and part in individual stocks.

The other point to keep in mind is your overall financial goals. For example, your mutual funds may already be returning enough for you to meet your various goals college education, retirement, down payment on a home, etc. Why jump into stocks (and incur tax on the sale of any profitable fund shares) just so you might earn yet a higher return but at a considerably higher risk?

(The preceding article was produced by the Institute of Certified Financial Planners and provided by William O. Woody, CLU, ChFC, CFP, of Stovall Woody Associates.)

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