When to Shun Mutual Funds

A reader writes: “In your disclaimer, you make a point of saying that most people should be in no-load mutual funds, not individual stocks. I would be quite interested in hearing your criteria for when individual is better. The big advantages I see for individual stocks are better control of taxes and better capability to allocate assets into various classes.”

Good question. It’s true that “tax-control” has its advantages.

For example, if I have a stock that goes up five-fold (I don’t have many) and another that goes to zero (I have quite few), I can give the big winner to charity — which is a cheaper way to give than giving actual cash — and sell the other for a tax loss, deductible up to $3,000 a year against my ordinary income. In a mutual fund, the gains and losses might have largely cancelled each other out, giving me little tax advantage in giving shares of the mutual fund to charity (since I might have only a modest capital gain in those shares overall), and no tax advantage from the loss within the fund (unless I sold my fund shares at a loss).

I’m not sure I buy your other “big advantage” — “better capability to allocate assets into various classes.” I think you can do most of the asset allocating you want by choosing the right funds.

Other advantages to going it alone choosing individual stocks: it’s more fun and interesting, and that may be worth something to you (although it’s not so much fun if you do really badly at it, as more than a few bright people do) . . . you can sometimes take advantage of your expertise in a particular niche (but do be careful of abusing inside information) . . . you can sometimes beat the pros, either because you’re just really good at investing (but few can, including few pros) . . . you can tread where most mutual funds dare not — namely, the stocks of companies too small for most funds to invest in (but these can languish for years and are often the riskiest stocks with the highest “transaction costs” for getting in and out — the widest spreads between the bid and the asked).

If parts of this comment are hard to follow, please feel free to ask more questions! On this, or any other topic. My answers will normally worth about what you pay for them.

Tomorrow: We Have a Flat Tax