The Case for Mutual Funds

By Dr. James M. Dahle, WCI Founder

Once a generation or so, investors go bonkers for a couple of years over a select few well-known stocks. They get bid up to ridiculously high prices at which point their earnings can no longer justify their price. That doesn't mean the price will crash, of course. Sometimes it just means their returns will be lower than other stocks for a prolonged period of time.

There are a few examples of this, which I list below. But even when times are good, we know bad times are probably coming. That's why the case for utilizing mutual funds vs. picking the most popular stock of the moment is so clear-cut.

First, though, let's take a look back at those moments in history when the champagne was really flowing and when picking the right stock could set you for life.

 

The Nifty Fifty

In the 1960s and 1970s, these stocks were called the “Nifty Fifty”. It was thought that they were “one-decision” stocks. You buy them once and hold them forever because they were so awesome. They included lots of well-known names such as Anheuser-Busch, Coca-Cola, General Electric, Polaroid, and Xerox. They were “blue-chips”. By the end of 1972, these stocks had an average Price to Earnings ratio of 42 while the S&P 500 had a P/E ratio of just 19. When the inevitable bear market came in 1973-1974, the Nifty Fifty (with the interesting exception of Walmart) fell much harder than the rest of the market, some as much as 90%. They were absolutely hammered over the next 10 years (although if you go out 30 years, they did about as well as the overall market).

But that's not the interesting part of the story. The individual stocks themselves are what's fascinating. Of the original 50, only 29 remain in business. 21 are no longer publicly traded. Most of these were simply acquired by other companies, but at least two completely disappeared and three others are nearly gone. Seven of the 29 remaining companies are not even in the S&P 500 anymore, i.e. they are no longer large-cap stocks. Only eight are still among the 30 stocks in the Dow Jones Industrial Average. The lesson? Picking the winners in advance turned out to be pretty difficult—certainly much harder than a coin flip, even with these “one-decision” companies.

 

The Dot-Com and Telecom Bubble

The next generation met their match in the late 1990s in the dot-com bubble. People forget that it was not just tech companies that bubbled up but also telecom companies. Even otherwise sensible investing books published in that era recommended a 5% tech allocation and a 5% telecom allocation. Most of you know the rest of the story: from peak to trough, the tech-heavy NASDAQ fell 78%. It did not return to its previous high for 16 years.

Telecom stocks received their own special beat-down. You've probably heard that Worldcom disappeared, but it's hardly the only one. Fifty companies went bankrupt. More than 400,000 jobs disappeared. More than $500 billion in investor money vaporized. IYZ is an ETF that was started by iShares in June 2000 (three months after the crash began). Its price was about $60. Today's price, 20 years later? About $30.

 

Current Fads

Our generation has become enamored with the FAANG stocks. Throw in some Tesla and a little Bitcoin, and you've got a combination of holdings that would describe a whole lot of “Robinhooders“. We don't yet know exactly how or when this will end. But end it will. Before we changed our Facebook Group moderation policy, there were a plethora of examples of the current stock-picking fad on display there:

 

The problem with individual companies is that their fortunes change. Top companies are rarely the same from decade to decade. Don't believe me? Watch this:

 

 

When you buy individual stocks, you take on what is called “Uncompensated Risk“. This is an important concept to understand. As a general rule in investing, the more risk you take on, the higher your potential return gets. That's called compensated risk. If you own a company vs. just lending money to a company, you're taking on more risk and should theoretically be paid more to do so. It all makes sense.

However, there are risks that you can take on that are not compensated. There is no additional return for taking on that risk. When it comes to stock market investing, uncompensated risk is any risk that can be diversified away. Why would the market pay you to take a risk that can be easily eliminated? It wouldn't. In stocks, the primary risk that can be easily diversified away is individual stock risk, i.e. the risk that a given company goes bankrupt or otherwise has a poor performance.

How do you diversify this risk away? By not simply buying a single stock. If you buy five stocks instead of one stock, your risk is significantly lower. If you buy 100 stocks instead of five stocks, your risk is again significantly lowered. If you buy 5,000 stocks instead of 100 stocks, that risk is essentially gone. It has been diversified away. If Sears goes bankrupt, it will not affect my financial goals one bit. Not only is picking stocks a loser's game, but it makes you look uneducated just to talk about it.

The easiest way to buy thousands of stocks is through a mutual fund. At its core, a stock mutual fund is simply thousands or even millions of investors pooling their money together to buy stocks. However, diversification is not the only benefit of the mutual fund structure.

 

The Case for Mutual Funds

A mutual fund provides the following benefits that are generally unavailable to an individual stock picker:

1. Instant massive diversification
2. Professional management
3. Pooled costs that benefit from massive economies of scale
4. Daily liquidity

 

Let's go through each of these benefits in turn.

 

#1 Instant Massive Diversification

Consider my favorite mutual fund, the Vanguard Total Stock Market Index. At the time I wrote this, it held 3,634 stocks. Yes, its six largest holdings are Apple, Microsoft, Amazon, Alphabet (Google), Facebook, and Tesla. Yes, those six holdings make up 19% of the fund. But even if Apple loses 40% of its value, my investment in this fund only falls by 2%. And if Visa, a company whose services you and I use every day, is completely wiped out, my investment only falls by 1%. That's the power of massive diversification.

 

#2 Professional Management

One of the best parts about mutual fund investing is that it is so easy. The ease of use is the main reason why mutual funds make up almost all of the available investments in 401(k)s, 457(b)s, IRAs, 529s, and HSAs. The reason they are so easy to use is because they are run by a professional team. That team analyzes, buys, and sells the stocks. They keep track of the dividends. They do the paperwork and the communication. All you have to do is put the money in (and even that can be automated), and then you can literally forget about it for decades if you want. Try doing that with your rental property and let me know how it goes. Want to go float the Grand Canyon for three weeks like me? Day traders can't do that.

 

#3 Economies of Scale

You would think that sort of service would be really expensive, right? Not necessarily. Even a fairly expensive mutual fund is only going to charge you about 1% a year for that diversification and management. With a very inexpensive index mutual fund, that expense ratio drops to 0-0.10%—essentially free. However, the expense ratio is not the only cost involved in a mutual fund. For instance, there are the actual costs of buying and selling stocks, such as commissions and bid-ask spreads. A massive mutual fund is going to get a much better deal there than Joe Individual Investor. A mutual fund can also lend securities to short sellers. Vanguard essentially gives 100% of its lending income back to fund investors. For the Vanguard Small Cap ETF (VB), that is about $40 million a year. That works out to be about 0.05%, essentially paying for its entire expense ratio. Individual investors aren't going to get in on that game.

 

#4 Daily Liquidity

On any given weekday afternoon, I can liquidate my entire mutual fund portfolio. By 4 pm ET, all my money is in cash. Admittedly, it is very unlikely I would ever want to do that, but it's nice to know that I could. If you've ever owned your own company, house, or an illiquid investment, you know that it may take months—or even years—to get your money out of it. Even if you can get your money out of it relatively quickly, you might have to “take a haircut” to get that liquidity. For example, if you want to get money out of a CD before it matures, you usually have to give up the last 3-12 months of interest. People sell their houses for 30% off all the time because they desperately need the liquidity. There are none of those concerns with a mutual fund.

If you use index mutual funds instead of actively managed funds, you get even more benefits:

1. No manager risk
2. Even more diversification
3. Incredibly low costs
4. Improved tax efficiency
5. A guarantee of market-matching performance
6. Much higher chance of better long-term performance

The case for mutual funds is strong. The case for index mutual funds is even stronger. One hundred percent of my public stock market investments are in just four index mutual funds (and equivalents):

• Vanguard Total Stock Market Index Fund
• Vanguard Small Value Index Fund
• Vanguard Total International Stock Market Index Fund
• Vanguard FTSE Ex-US Small Cap Index Fund

I once owned an individual stock for about two weeks. That was enough for me. If you look at my entire portfolio, 85% of it is in publicly traded mutual funds. The remaining 15% is invested in private real estate investments, but most of that (95%+) is in mutual fund-like private real estate funds with multiple properties or loans. Overall, 98% of my retirement portfolio is in some type of diversified fund.

 

My point is clear. You do not need to pick your own stocks to successfully reach all of your investing goals. In fact, trying to do so is likely counterproductive. Mutual funds are the best way for the vast majority to invest. Stop speculating. Stop trying to beat the market. Control what you can control and quit worrying about the rest. Eliminate the effects of greed and fear from your financial life. Make a reasonable written investing plan. Fund it adequately. Follow it even when you wonder if you should.

Follow it even when your friends are bragging about how much they made last week on Tesla or Netflix or Bitcoin or whatever the next Nifty Fifty thing is. Yes, mutual funds are boring. Good investing is boring investing. If the most exciting thing in your life is your investments, you're doing life all wrong.

What do you think? Do you invest in mutual funds? Why or why not? What is the most important benefit of a mutual fund to you? Comment below!