Before mutual funds became the de facto standard investment option in 401(k) plans, before 401(k) plans became the de facto standard retirement savings option, most people invested in individual securities. Sure, mutual funds existed back then, but they often carried large commission charges, even larger front-end loads, and, to discourage you from leaving, mutual fund companies imposed large back-end fees.
Simply stated, mutual funds cost too much for the average investor. And by “cost,” the reference isn’t to the fund’s underlying expense ratio, but to the actual out-of-pocket costs you’d have to pay for the privilege of pooling your investment money with others.
For investors with small sums of money, mutual funds represented a fast way to secure professional management. They also provided an avenue towards greater diversification (although academic studies would later show it was possible to create a diversified portfolio with only a dozen or so securities).
These days, almost everyone invests in mutual funds. With their omnipresence within 401(k) plans, it’s almost impossible to avoid them. Fewer people today are familiar with the benefits of building portfolios of individual securities. Instead, they rely on the “one size fits all” culture of financial products.
Here’s the reality: one size does not fit all, especially for retirement.
How Can You Retire More Comfortably?
This is the aim you ultimately seek. What is a comfortable retirement to you? For most, it involves some sense of freedom. Freedom to do what you want. Freedom from worrying about the uncertainty of tomorrow. In short, freedom to choose your own destiny.
Consider what this means regarding your retirement investments. Owning investment products might sound like a good idea because you’re pooling your money with others to achieve economies of scale. But what are you giving up in exchange? Are mutual funds really in your best interest when you could create a private portfolio focused on your needs alone?
It’s like the difference between riding public transportation versus a chauffeured limousine. Yes, the former costs less because you share the ride with others, but it limits you to only certain stops. The latter, on the other hand, takes you exactly where you want to go. This highlights the first benefit of investing in individual securities.
Reason #1: Individual Securities Give You More Control and Flexibility.
“For larger portfolios, transitioning from products to individual securities may be in the best interest of retirees because it can allow them to have more control and flexibility over their investments,” says Mina Tadrus, CEO of Tadrus Capital LLC in Tampa. “However, it’s important for retirees to carefully consider their financial knowledge and expertise, as well as the time and energy they have available to manage their own investments, before making this transition.”
With mutual funds, you cannot explicitly match your investment objectives with your investments. This stands out as the most critical advantage of individual securities. For example, if you have a payment of $10,000 in ten years, you can buy a U.S. Treasury with a face value of $10,000 that matures in ten years and rest in comfort knowing that payment will be taken care of. You can’t do that with mutual funds.
“By investing directly in stocks and bonds, retirees have more control over their investment decisions and can tailor their portfolio to their specific financial goals and risk tolerance,” says Garett Polanco, CIO at Independent Equity in Fort Worth, Texas. “This can be more appealing to retirees who have a strong understanding of the financial markets and want to have more control over their investments.”
When you take a deeper dive into the two major asset classes, you gain more clarity as to why individual securities tend to deliver you more favorable outcomes.
Is it better to invest in individual bonds or bond funds?
It is well understood that owning bond funds is not like owning individual bonds. This reveals the second reason you’d be better off moving from investment products to individual securities.
Reason #2: Individual Bonds Are More Predictable Than Bond Funds.
“Investing in individual bonds carries some advantages, including reduced market risk (when you hold bonds to maturity), lower risk of default (for higher rated bonds), consistent income from interest and the ability to decide which bonds to invest in (including terms such as maturity, credit rating, issuer industry, etc.),” says David Rosenstrock, Director and Founder of Wharton Wealth Planning in New York City. “If interest rates are rising, then individual bonds and bond ladders could be a good strategy since bond prices are dropping while yields are on the rise. A bond ladder strategy, or buying a portfolio of bonds with different maturities that are spread out, will often allow you to take better advantage of a rising interest rate environment. As shorter dated bonds mature, you can reinvest the proceeds in higher yielding bonds and capture higher interest rates.”
This isn’t to imply moving to individual bonds doesn’t have a few drawbacks.
“Investing in individual bonds does, however, have some additional risks as well,” says Rosenstrock. “For example, it’s important to understand the correlation between interest rates and bond prices and yields, so you’re not buying or selling at the wrong time. When you diversify with individual bonds, the burden of choosing bonds lies with the investor rather than a fund manager. You may need to spend time researching different bond options to decide which ones are the best fit for your portfolio. In addition, you may need to invest larger amounts than you would with a bond fund to achieve the same level of diversification when choosing individual bonds.”
While you can easily grasp the difference between bonds and bond funds, seeing the difference between stocks and stock funds presents a challenge to those less aware of the intricacies of portfolio management.
Is it better to invest in individual stocks or stock funds?
Recall the original reason people wanted to invest in mutual funds. They desired both professional management and felt they could better diversify through mutual funds. This worked as long as mutual fund portfolio managers maintained small portfolios. As mutual funds became more popular through 401(k) plans, their assets grew, and so did the number of portfolio holdings. Today, it’s not unusual to see mutual funds with up to 1,000 securities or more.
That might be an example of “over-diversification,” which leads to the third advantage offered by building your own portfolio.
Reason #3: It’s Easier to Diversify Using Individual Securities.
“Investing directly in stocks and bonds allows retirees to diversify their portfolio and invest in a variety of securities,” says Polanco. “This can help mitigate risk and provide a level of protection against market downturns or economic recession.”
Of course, when many ask if stocks are better than stock funds, what they’re really asking is:
Can you beat the market with individual stocks?
Those that ask this question may be confused about their proper goal. Is it to live a comfortable retirement or to have a tombstone epitaph that reads: “Here lies John Doe. He Beat the S&P 500.”
Clearly, beating the market is not an appropriate benchmark for an individual. Life is too complicated. Unfortunately, the Securities and Exchange Commission requires mutual funds to measure their performance against a benchmark (usually a market index). You probably have your own “benchmark” (usually progressing towards obtaining a personal financial goal).
You want to move forward and avoid moving too far backward. Avoiding losses, therefore, is more significant than beating the market. It’s easier to avoid losses with individual securities. In other words…
Reason #4: Individual Securities Help You Reduce Downside Risk.
“By investing directly in stocks and bonds, retirees may have the potential to earn higher returns compared to investing in investment products like mutual funds or ETFs,” says Polanco. “This is because investment products may charge fees or have lower returns due to their underlying investments while investing directly in stocks and bonds allows the retiree to choose specific securities and potentially achieve higher returns.”
Finally, if you’re a typical retiree, your net worth isn’t limited to retirement savings plans. You’re likely to invest outside those options as well. If this is the case, you might have the following question.
Are individual securities better than mutual funds for taxable accounts?
Here, shifting from an investment product strategy to an individual security strategy has one very critical advantage.
Reason #5: You Can Manage Your Taxes Better With Individual Securities.
“In most cases, it makes sense to reduce the layers of fees, increase the customization of the portfolio and position oneself to better manage taxes,” says Stephen Taddie, Partner at HoyleCohen, LLC in Phoenix. “A common improvement is moving away from the annual realized capital gain distribution that many funds payout at year end to a program where those gains or losses are realized in the portfolio with an eye to what is best for you.”
As with mutual funds themselves, these five reasons are also not “one size fits all.” You may have circumstances where, despite clear and obvious advantages, it remains in your best interest to keep your investments in products.
“Sometimes a transition may not make sense,” says Taddie. “A client holding low cost basis managed products in a taxable portfolio may not want to immediately transition and realize a large capital gain just to better position themselves in individual securities for the future. Gradually working towards that goal while managing tax liability certainly makes sense. A very elderly investor with low cost basis managed products in a taxable account may be better served by planning to use the step-up in cost basis at death rule to eliminate the tax on the embedded gain to transfer wealth to the next generation. Depending on the percentage of the gain and size of the portfolio, the potential tax savings could trump lower expenses and better performance depending on the timing of the triggering event. After the step-up in basis, the next generation could then transition their portion to individual securities without tax liability. A client (taxable or tax differed) that cannot get past a singular focus on the performance of each individual investment held in their portfolio is probably better served staying invested through market cycles in a more expensive program than transitioning to only engage in the self-destructive in and out of market transactions. In cases where there are exit/surrender fees involved, the timing of the transition may depend on mitigating the fees, so the transition is more sensible.”
When people retire, they often wonder if it’s better to keep their assets in the plan of their former employer or roll them over into a privately managed IRA account.
If you keep it in the plan, unless the company offers a self-directed option, you’re generally limited to investing in products like mutual funds. This might not be in your best interest, as transitioning from products to individual stocks and bonds offers several important benefits.