Let’s revisit the basics of investing in stocks
Continuing the theme from last column, I thought it would be worth looking at the advantages and disadvantages of the three main ways to invest in stocks. The last column was hopefully convincing on the benefits of stocks to achieve higher returns over cash, GICs or bonds.
Pension funds, including the Canada Pension Plan, will have exposure to the equity markets. However, these funds are broadly diversified across many asset classes and investment decisions are out of control of the individual investors, so we will quickly move the discussion to areas where we have control.
Funds
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Mutual funds have long been a mainstay of equity investing. Besides stocks, there are a wide array of bond mutual funds and balanced funds that hold both stocks and bonds. The earliest mutual funds date back a century, becoming popular in the 1970-1990 period. There are estimated to be 10,000 mutual funds available in the U.S. and 3,400 in Canada, with about $18 trillion of assets under management.
The advantages of mutual funds are their wide availability through banks and financial advisors, accessibility for small investors, and broad diversification of investments. For many people a relationship with a financial advisor is important, as they instil discipline in the investing process. The disadvantages are high fees, often representing 1.5 to two per cent of assets annually, and while portfolios’ holdings are disclosed, investors rarely know what they really own. Another negative is that less than 10 per cent of funds beat their respective benchmarks over the long term.
The data on mutual fund performance led many to believe beating the market was impossible — something that is taught in finance class. It also led to the development of exchange-traded funds or ETFs, which are structured to replicate the performance of an index. Because they mirror an index, management is simpler and fees are much lower, usually in the range of 0.05 to 0.5 per cent of assets, depending on the size of the ETF. They trade on stock exchanges just like stocks and, like mutual funds, offer broad diversification with one holding. A main disadvantage is once again, investors don’t really know what they own.
Popularity over the past two decades led to proliferation and there are now 3,600 ETFs in the U.S. and 800 in Canada, rivalling the number of stock listings. It is estimated they control 25 per cent of the total market cap and have more assets than mutual funds. While the original intent was to own the entire S&P 500 or other such broad index in one holding, they expanded to single-industry ETFs, such as gold, oil, health care et cetera. They further proliferated to the point where there are now single-stock leveraged ETFs, which seems to defeat the purpose of an ETF. A disadvantage of both mutual funds and ETFs is there is steady churn, where unsuccessful ones are shut down or merged.
Single stocks
The third way to own equities is through the purchase of individual company stocks. This is my preferred route, although I use single-industry and international ETFs somewhat. The advantage of owning individual stocks is you know what you own and can review each company’s financial performance. While many will suggest there are just too many companies to look at, I would similarly suggest there are also too many mutual funds or ETFs to look at. Owning individual stocks creates great learning opportunities and improves business and financial literacy.
In late 1992, I transferred my RRSP into a stock account when interest rates dropped into the six to eight per cent range, searching for higher return potential. I selected four mutual funds and four stocks. Over time the stocks did much better than the mutual funds, so I moved entirely into stocks. At the time you had to buy stocks through a broker. Neither internet investing accounts nor ETFs were available. Transaction fees were about $150 per trade so you had to make a substantial-sized purchase to justify the expense. It is so much easier these days, especially for small investors starting out. Whether investors choose mutual funds, ETFs or individual stocks, there is one important similarity. Investors tend to only achieve about half the return the market provides. Performance-chasing, over-trading, and attempting to time the market are the three main culprits for underperformance.
Mutual fund investors tend to sell funds that have performed poorly and buy those with better recent records, only to see the reverse happen. While ETFs were designed to be passively held, they have become actively traded, and most people think they know when the market, or a stock, will go up or down. While beating the market is possible, timing it is not.
The main antidote to these culprits is careful initial selection, portfolio design, and a long holding period. I still hold one of the four stocks purchased late in 1992. Following these antidotes helps you stay calm during periods of market and economic turbulence.
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