Today I’m continuing our 4-part series on investing in the stock market by talking about the two most effective ways to invest in stocks.
I’m also sharing the pros and cons of each method so you can decide what’s best for you.
In this episode, you’ll learn three BIG things:
- Why individual stocks have higher expected rates of return than funds
- What hidden costs you need to look out for when investing
- How to decide between individual stocks vs. mutual funds vs. ETFs
If you want to make sure you fully understand the different vehicles you can choose when investing in the stock market for retirement, you’ll enjoy this episode.
How to Listen to Today’s Episode
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- S&P 495 vs S&P 5 [Chart]
- ETFs vs Mutual Funds [SW Ep. #54]
- Bid-Ask Spread: Free Trades Aren’t Free [Define Financial]
- Are ETFs Better Than Mutual Funds [Define Financial]
- Rydex S&P 500 Fund [Morningstar]
- William Bernstein’s Research:
Retirement Investing #2: How to Invest in Stocks + Pros and Cons
Taylor Schulte: Most people don't have the time or expertise to research and manage 50 or more stocks. Individual stock pickers usually end up with really poor diversification and really highly concentrated portfolios.
Welcome to the Stay Wealthy Podcast. I'm your host Taylor Schulte, and today is part two of our four-part series on investing in the stock market, not the bond market, not the real estate market, but the stock market, just plain vanilla stocks.
And I'm interested in this deep dive into stocks because the US stock market has been screwing up upwards for over 11 years now, and it's without a doubt causing a lot of questions and challenges for those that are investing for retirement.
Things like will US stocks keep going up? What kind of stocks should you be investing in? How do you build the right portfolio? And most importantly, how do you avoid making mistakes that might jeopardize your retirement plan? I'll be diving into all those questions and more, and I look forward to hearing from you about what questions you have about investing in the stock market.
For all the links and resources mentioned today, head over to youstaywealthy.com/82.
Okay, to kick off part two of our series on investing in the stock market, I want to talk about the two primary ways that you can invest in stocks. And I know this sounds really simple and basic, but I promise I've got some really fun stuff to share with you today that will not only teach you something new and enlightening but will also set the stage for the final two episodes of this series.
So the first way that you can go about investing in stocks is by buying individual stocks. So for example, Apple, Amazon, Tesla, and Microsoft. These are individual stocks that you can go out and purchase individually and own them in your investment and retirement accounts.
The second way you can invest in the stock market is by buying a single fund that does the stock buying for you. This could be an actively managed fund or a passive index fund, and it could be a mutual fund or an exchange traded fund.
Either way, one quick purchase of a fund gives you ownership of hundreds, if not even thousands of stocks without you having to do any of the research. So I want to break down the pros and cons of each of these two ways that you can invest in stocks. I want to start with buying individual stocks and let's talk about the pros and cons of going this route.
So the first pro is investing in individual stocks is low-cost stocks don't have expense ratios. The operational expense of a stock is essentially baked into the value of the business and the current price of that stock. So with the lack of any expense ratios and transaction fees, pretty much at zero these days, it's really only gonna cost you the bid ask spread, and whatever your time is worth to invest in a portfolio of individual stocks. So the first pro is that they're low-cost.
The second pro is that you should expect higher returns. And here's the thing, investing in individual stocks is risky. I think we can all agree that investing in individual companies is risky, and as you know, the more risk you take, the more of a reward you should expect.
Now, there is some element of skill here. You can't just aimlessly buy individual stocks and have this expectation that you're gonna have higher returns. But if you're taking a prudent approach to buying individual stocks, personally, I would expect a higher rate of return.
If I'm going to take more risk, I better get a higher rate of return over a long period of time. So investing in individual stocks, the second pro is higher expected future returns due to the risk that you're taking.
The third pro is the ability to control your tax bill. So unlike some certain types of funds, you don't have to worry about capital gains distributions coming at the wrong time with individual stocks. You can decide when to sell them and realize the taxes when it's best for you.
So those are the three pros, low costs, higher expected returns, and the ability to control your tax bill. Let's get into the cons.
So the first is the lack of diversification. You might need to research and manage 50 or even more stocks in order to get close to even having a diversified portfolio. And since most people don't have the time or expertise to research and manage 50 or more stocks, individual stock pickers usually end up with really poor diversification and really highly concentrated portfolios. So the first con lack of diversification.
The second is that it's time-consuming. As I mentioned, it can take a lot of time to manage individual stocks, stay up to speed on the daily changes of each company, and conduct that ongoing research. Also, don't forget about the challenges of trading individual stocks and having to navigate the bid-ask spread every time you buy or sell.
It's a really time-consuming job to manage and transact these individual stocks. Really quick, I've mentioned bid ask spread a few times. Now if you don't know what the bid ask spread is or how to navigate that, I wrote a pretty comprehensive blog post on the topic that I will link to the show notes and you can learn more there.
The third con is that for most retirement investors, individual stocks are just too risky. Yeah, I talked about expecting this higher rate of return with individual stocks, but for most retirement investors, you don't need higher rates of return. You need to manage your risk appropriately as you enter one of the most vulnerable time periods of your financial life.
So for most retirement investors, individual stocks are just too risky and it's not just the penny stocks that are risky. Remember, three and a half years ago, General Electric, a common large-cap company that we all know by name was trading at $30 per share. Today as of this recording, General Electric is trading at $6 per share. That's an 80% loss in just three and a half years.
So it's not just those small cap or penny stocks that are risky companies that we all know by name can certainly fall dramatic amounts, and in my opinion, I think it's just too much risk for that retirement investor.
The last con is that it's just about impossible to outperform broad base index funds on a consistent basis. I know you've heard me talk about this before, but I want to share a recent chart that you may or may not have seen this year that I think illustrates this better than anything else I've seen before.
So from January to July of this year, and this is just when the chart was published, but you could do this any year at any point of the year, this is a common statistic, but from January to July of this year, the S&P 500 was up about 2%. However, the five largest stocks in the S&P 500, that's Facebook, Amazon, Apple, Microsoft, and Google, just those five stocks on their own were up 35%.
So let me say that again. From January to July of this year, the s and p 500 was up about 2%. However, the five largest stocks in the S&P 500 were up 35%. In other words, those five stocks, those five of the largest stocks contributed to all of the gains in the S&P 500. The other 495 stocks during that same time period had a negative 5% return.
How on earth would anyone have known which of the five stocks to own in the S&P 500 in 2020 or any other year for that matter? How would anyone have known which of those five stocks to own?
Oftentimes to make matters worse, the stocks that do well this year are the ones that go on to do poorly next year. And vice versa, you would need quite the crystal ball to time all of this perfectly in order to consistently beat the market indexes.
So again, it's just about impossible to outperform these broad based index funds on a consistent basis, which again, I think is the fourth and final con of investing in individual stocks. Now, if you just love buying individual stocks and you can't ever imagine letting that go, one prudent solution to consider is to establish a cowboy or cowgirl account.
And you might have heard me talk about these accounts, but in short, these accounts should never represent more than 5% of your total investible assets. And this is your space to have fun, to buy individual stocks to bet on the technology sector, or maybe even finally dabble in cryptocurrency and buy some Bitcoin or Ethereum or whatever else is out there.
These accounts, they let you just scratch that itch without jeopardizing your retirement plan. And that's the important part. My suggestion is that you approach these accounts with the mindset that everything could go to $0 and you would know that you should be with that outcome because your long-term plan, your harder-earned savings, that other 95% is invested prudently.
So I would go in with the mindset that this cowboy or cowgirl account could go to $0 and just be okay with that. Now, chances are slim that it goes to zero, but I think that's the right mindset to go into when, when you're playing around in an account like this.
Okay, the second way you can invest in stocks, like I mentioned at the top of the show, is through a fund. Again, this could be a mutual fund or an exchange traded fund. So let's talk about the pros and cons of this approach.
The first pro is that like buying individual stocks, funds are pretty low-cost these days. Expense ratios have come down dramatically and many funds, they cost close to $0 to own. So this means that you can get broad-based diversification and own hundreds or even thousands of different stocks with one single purchase at a really low cost.
And remember, the best predictor of future returns is the underlying cost of an investment. So this is a big one to keep an eye on, and it's a good one to keep in mind when going out there and buying stocks.
The second pro is that buying funds saves you time because one single fund can give you access to hundreds or even thousands of different stocks. You don't have to spend time researching individual securities and, and trying to manage them on a daily basis. The fund company or the index provider is gonna do that for you. So by doing that, by choosing a fund, one single fund, giving you broad-based diversification, it saves you a lot of time.
The third pro is diversification. Even if you only build up the courage to buy one or two or three funds, you're immediately more diversified than someone who's trying to buy individual stocks. You again, you're owning hundreds or even thousands of stocks with just a quick purchase.
And as you know, proper diversification is one of the key ingredients to creating a stable, reliable income stream when you're in retirement. And the only way to generate healthy risk-adjusted returns. So diversification is wildly important and it's one of the pros of investing in funds.
The fourth and final pro is the ability to automate your savings and investing and buying fractional shares using funds. I know that's a lot. Let me explain. Let's say you want to save a hundred dollars a month into your investment account and you want that a hundred dollars to immediately be invested in your chosen investments.
The only way to do that at most places is using funds. If you wanna invest in individual stocks, you would have to transfer that a hundred dollars and then go log into your account and take that a hundred dollars and invest it in the individual stocks that you want to invest in. And you cannot, in most places, buy fractional shares of individual stocks. That a hundred dollars is only going to go so far with mutual funds or in some exchange traded funds.
You could just automate all that. You can send a hundred dollars a month to your investment account and tell it to automatically buy a certain set of mutual funds. So the ability to automate that process and buy fractional shares is one of the pros of using funds versus individual stocks.
All right, so the four pros again to recap, fund prices and costs are pretty low these days. Number two, it saves you time. Number three, diversification. And then number four, the ability to automate that investing program and buy fractional shares.
Okay, cons of buying funds.
The first con is transparency can be an issue, especially with mutual funds. If you don't know what to look for and how to find it, you can end up buying a mutual fund that either one contains securities that are much riskier than you expected. When you read that fact sheet overview or two, you might find that the fund you invested in has higher than normal fees that weren't initially obvious when you made that purchase. So transparency can be an issue, especially if you don't know what to look for and how to find it.
The second con is that while many mutual funds are very low cost, there are still some crazy expensive funds out there on the market that have hundreds of millions of dollars invested in them. For example, the RX s and p 500 fund get this, the RX S&P 500 fund that simply tracks the S&P 500 has an annual fee of 1.6800000000000002% and almost 150 million is invested in it. In other words, mom and pop retirement savers are paying Rx in that fund. They're paying them about two and a half million dollars per year just to track the S&P 500 for them, which is essentially free through custodians like Vanguard, Fidelity, and Schwab.
And again, going back to the issue with transparency, if you don't know what you're looking for, you might think that an S&P 500 fund is gonna be low cost just because it tracks the S&P 500 and you've learned that those are typically lower cost. If you don't look under the hood and find out that there's a 1.6800000000000002% annual fee, you could really be doing some damage to your investment portfolio.
So the second con, while many funds have low cost, there are still some crazy expensive stuff out there that you have to keep an eye out for.
Number three, if you're not careful, some funds can cause major tax issues and that's because a fund manager is doing the buying and selling for you and they're triggering taxable events when they need to or they want to not when it's best for you. There are tax-efficient funds out there, but it does take some more work to navigate the tax issues in that fund format versus buying individual stocks where you get to decide when to capture losses or trigger those gains.
So I'm sure you picked up on my preference between buying individual stocks versus using low-cost funds. While I love buying individual stocks in my cowboy account and I enjoy supporting and following a handful of publicly traded companies, I do believe that using funds to build a sound diversified investment portfolio is the most prudent approach, which begs the question, what's better than mutual funds or exchange traded funds?
You might remember I had Ryan Kerlin on the show late last year who made a strong case for owning ETFs while he's a tad conflicted working for an ETF provider, he's a super smart guy and he brought up a lot of valid points in that interview. If you missed it or you wanna give it a second, listen, it's episode number 54 and I will link to it in the show notes for you.
But shortly after that interview, I was feeling a little bad for mutual funds, so I decided to do some additional research and write a pretty comprehensive blog post defending mutual funds. And I'll link to that full post in the show notes so you can kind of get both sides to the story and come to your own conclusion.
But the three main things I highlighted were this one, mutual funds are not more expensive than ETFs. That's a common claim that's made that ETFs are cheaper and that's just not true. There are high-cost mutual funds and there are low-cost mutual funds. Similarly, there are high-cost ETFs and there are low-cost ETFs. So that's kind of misconception number one.
The second thing I talked about and highlighted were ETFs can help you defer taxes, but there are better maybe smarter ways to manage your tax bill rather than using an ETF to defer those taxes. Remember, when you defer those taxes using an ETF, in some cases you're creating a giant future tax liability in retirement.
So there could be, depending on your situation, smarter ways to manage that tax bill rather than just deferring it using an ETF. Also, if you're investing in an IRA or a 401k, you can just ignore this whole thing about deferring taxes using an ETF since you're already using a tax-deferred account.
So it doesn't really matter whether you're using an ETF or a mutual fund, you have a tax-deferred account, you don't need to worry about the tax deferred benefits of an ETF.
Number three, be careful with bond exchange traded funds that own corporate and municipal bonds. William Bernstein did a bunch of research and published a pretty extensive paper highlighting the problems that occur when trading corporate and municipal bonds in ETF format.
And I'll spare you the details right now about the trading liquidity issues, but the cliff notes are this, investors in a corporate bond ETF could end up paying more for the same bonds than investors in a corporate bond mutual fund.
So in short, if you own a corporate bond or a municipal bond, ETF, it may not be the best format. A mutual fund format actually might be better.
Of course, you need to do your own research, look under the hood, read William Bernstein's paper and come to your own conclusion. But that's the cliff nodes. So which should you choose ETFs or mutual funds? I, you know, I wish I could give you a blanket answer here. They are both, you know, really, really good vehicles to invest in the stock market, unfortunately which is right for you is an it depends type of answer.
There's a lot of different variables at play here. Personally, we prefer using mutual funds for most asset classes, especially like I said, when allocating to bonds. Also, since we only work with people over the age of 50 who are in retirement or close to it, we mostly oversee and manage assets in tax-deferred accounts.
So the perceived tax benefits of an ETF don't really apply. That being said, rules around ETFs are rapidly changing and there are some new players that are getting into the market and shaking things up.
And so we're actually revisiting things. We're doing some additional research and determining how and if we might implement some additional ETFs in the future. So hopefully I have an update for you later this year or early next year. But like anything, we want to see the actual data, we want to see the academic research that supports any changes that we make to a holding or to a position in a portfolio.
For the links and resources mentioned today, head over to youstaywealthy.com/82. Thank you as always for listening and stay tuned for part three of our four-part series on investing in the stock market, which airs one week from today.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.