Stocks Or Funds Stocks give you a shot at explosive gains, while funds offer a smoother ride. Here's how to choose which is best for you.
By Jason Zweig Reporter associate: Pat Regnier

(MONEY Magazine) – Whether you've been investing in equity mutual funds or in individual stocks, the past few years have been a treat. With the stock market regaining its momentum and marching to record highs in February, the average fund that buys U.S. stocks boasts an annualized 24.4% gain over the past three years, turning a $10,000 investment into nearly 20 grand before taxes. Meanwhile, shares of blue-chip companies like General Electric and Coca-Cola have zoomed (222% and 155% respectively), while many tech stocks, including Intel and Microsoft, have more than quadrupled in value.

But all that success can't eliminate one nagging question: Could I have done even better? After all, investors have had to gut it out through some horrific volatility, with the Dow industrials index gyrating by 1% or more in one out of three trading sessions over the past four months.

And while annual stock fund returns of nearly 25% a year are certainly welcome, the fact remains that those gains are as much a reflection of the upward march of stock prices as of fund managers' prowess. In fact, over the past three years only a handful of domestic-stock fund skippers--7.2%, to be exact--have been able to beat Standard & Poor's 500-stock index, the bogey against which most managers are judged.

So it's only natural that if you are a fund investor, you've probably wondered whether you might be able to boost your returns by putting some of your money into individual stocks. And if you stick mostly to shares of specific companies, now and then you've perhaps considered insulating your portfolio from the wild swings of the market by adding a mutual fund or two to your stockholdings.

This cover story will grapple with the fundamental issue of whether right now you would be better off investing primarily in stocks or in stock-oriented funds. There is no single answer, as the three profiles of investors that accompany this story show. Instead, where you come out on the stocks vs. funds issue will depend on your answers to questions such as what size returns you need to reach your goals, how much risk you're willing to take in pursuit of those returns and how much time and effort you are prepared to devote to investing.

The starting point, though, is the same for all of us: understanding the key differences between stocks and funds. So we'll begin with a cold-eyed, realistic evaluation of the advantages and disadvantages of each choice. Then we'll discuss ways that fund investors might fare better by branching out into stocks, and how stock owners might improve their results by diversifying into funds. For those who decide to stick mostly with funds--or are considering rounding out a stock portfolio with a fund--"Funds Even Stock Pickers Can Love" (starting on page 104) highlights 10 compelling choices. For specific stock recommendations, check out "Bigger Is Better" (beginning on page 126), which shows you how to profit from one of the hottest opportunities in today's market: the boom in mergers.

One final note before we get to the nitty-gritty of stocks vs. funds. In recent years, returns have been so generous and have come so effortlessly that many investors' expectations have become as hopelessly bloated as the valuations of many companies' shares. So before you throw money into either stocks or funds, pull back for a second and remind yourself: Investing involves risks as well as rewards. While stocks and equity funds still offer the prospect of lucrative gains long term, at some point the market will stumble, at least temporarily. Gains of 25% a year simply will not go on forever. If you blindly pursue reward alone, you will someday be brutally reminded that risk never went away.

THE CASE FOR (AND AGAINST) FUNDS

Considering that more than $830 billion has flowed into stock mutual funds over the past five years alone, it's obvious that millions of investors are well versed in the advantages of funds. The biggest plus, of course, is that you don't have to decide which stocks to buy or sell, or monitor their performance; a fund's portfolio manager does that for you. And since the typical equity fund holds roughly 120 stocks, you get instant diversification. That doesn't mean your fund's value won't suffer when the broader market declines, but it does prevent your investment from being blown to bits if shares of one or two companies crash and burn.

Perhaps best of all, because stock funds are available in so many investing styles (from funds that focus on small companies to ones that own dividend-paying stocks or foreign securities), and because most funds require a minimum initial investment of no more than $1,000, you can easily build a diversified portfolio tailored to your financial goals and risk tolerance for well under $10,000. That would be virtually impossible with individual stocks--and would require a great deal more effort.

But our love affair with mutual funds has also tended to cloud our vision, allowing us to overlook funds' drawbacks, which can be substantial. Let's start with fees. Yes, by sticking to no-load funds, you can avoid paying the sales commissions that help push up the cost of buying individual stocks. But unlike stocks, funds come with annual management and administrative fees. And all funds also pass along invisible transaction costs to investors whenever a fund's manager buys and sells securities. All these expenses directly siphon off a portion of your return.

How much does this affect what you actually earn with your funds? Probably a lot more than you think. Consider this: The average stock fund today has an expense ratio of 1.41% of assets and incurs annual trading costs of roughly 1.39%. That means you are paying 2.8% a year, on average, for the convenience of investing in funds. It's largely because of this expense hurdle that over periods of a decade or more, 80% of U.S. diversified stock funds underperform the S&P 500. In the past 10 years, in fact, the average U.S. diversified stock fund lagged the S&P 500 by 2.3 percentage points a year--just about what you would expect, given the expense figures we've just outlined.

We're not suggesting that funds are failing you if they don't beat the market; indeed, your fund may compensate for submarket returns by providing a smoother, less risky ride. Still, fund expenses erode returns--and to the extent you invest in funds, it's wise to seek out portfolios that keep their expenses below the average for their peers.

Another major shortcoming with funds: They can be a tax nightmare. Mutual funds distribute to shareholders virtually all the income and capital gains the portfolios realize over the course of a year. Unless you own your fund in a tax-advantaged account such as a 401(k) or an Individual Retirement Account, you will owe taxes on those gains--even if you automatically reinvested the dividend or capital-gains payments back into the fund.

In other words, unlike stock investors, who decide when to buy or sell their holdings, fund investors have no control over when profits are taken on the stocks in the fund's portfolio. (You can decide, of course, whether to sell the fund itself. For advice on how to minimize your tax bill when you do unload fund shares, see "Four Lessons from Your 1040" on page 73.)

This lack of control means that fund investors can actually owe taxes on gains even when their fund suffers a loss. Say, for example, that at the beginning of 1997 you had put $10,000 into Invesco Asian Growth Fund. The fund lost 38.5% last year but paid out 21% of its net asset value in capital-gains distributions in December. That means that, at a 28% tax rate, you'd owe $364 in tax--even though you lost almost $4,000 for the year.

What's more, you can even be hit with a tax bill for capital gains you didn't earn: When you invest in a fund, you acquire a portion of the unrealized capital gains embedded in the portfolio. If securities that have already appreciated are sold at a profit, a portion of those gains go to you. Thus if you buy shares of a fund just before it distributes a gain, you will owe taxes even though the value of your investment hasn't climbed.

If you hold stocks rather than funds, of course, that would never happen. You'd also have complete control over when you take profits and thus when you owe payments to the federal Treasury. You can even avoid capital-gains taxes on a stock altogether by passing it on to an heir rather than selling it. Of course, if you invest in stocks that pay dividends, you will have to pay income tax on those payouts, even if you buy additional shares of stock through a dividend-reinvestment plan.

THE CASE FOR (AND AGAINST) STOCKS

So why wouldn't everyone rush to buy stocks? You have a shot at earning higher returns, you don't have to pay portfolio-management fees, and you get to control your tax obligation. And while it is true that you face brokerage commissions when you trade stocks, careful investors can hold that cost down by following a buy-and-hold strategy and perhaps considering discount brokers or even buying stocks directly from the company. (More than a thousand companies sell stock directly to investors; for details on how this works, see the box on page 100.)

Technological change has also made stock research more accessible. As recently as a few years ago, the suggestion that an individual investor could get the same quality investing information as the pros was absurd. But today, with the advent of inexpensive yet powerful PCs, affordable stock-screening programs on CD-ROM and dozens of sites on the Internet devoted to stock analysis, investors willing to expend the time and brain power can analyze the prospects of thousands of companies. These tools can't guarantee you'll make money, of course, but they can certainly help you scout out timely opportunities you might not otherwise find.

But just as funds have hidden shortcomings, so too do stocks. One of the most troublesome: underestimating the trading costs. For example, if you buy 100 shares of a $43 stock (the average price of a company on the New York Stock Exchange) from discount broker Charles Schwab, you will pay a commission of $29.95 to $55. That translates to as much as 1.3% of the amount of your investment. That may not sound too bad, but there's another transaction cost (often overlooked by individual investors) known as the spread. Essentially, this is a markup equity traders charge for holding stocks in their inventory until investors are ready to buy them. (Technically, it is the difference between what is known as the ask price for a stock--what you pay--and the bid, which is the price you would get if you immediately sold the stock back to the broker.) The spread generally varies from as little as 0.5% of a stock's price to as much as 6%, depending on such factors as the market value of a stock and how actively it trades.

Even assuming a relatively small spread of, say, 1%, once you tack that on to the 1.3% commission we mentioned, you're talking trading costs of 2.3%. Add in another round of costs when you sell, and even if your stock has jumped 10%, you are left with less than a 6% gain. Deduct 28% of that for taxes, and your 10% has shriveled to around 4%. You can comparison shop for lower commissions among online brokers. (Two sites worth a visit are www.gomezadvisors.com and www.onlineinvestors.com.) But even the wonders of cyberspace can't eliminate the spread and taxes.

The best way to cut trading costs is to trade less. By doing that, you'll also be able to take advantage of the new 20% maximum tax rate on capital gains, now available for profits on investments that you've held more than 18 months. Although trading stocks like hot potatoes is exciting, it's simply not good for your financial health. In a new as-yet-unpublished study that tracked the stock trades of 64,000 investing households, University of California-Davis finance professors Terrance Odean and Brad Barber estimate that the typical discount brokerage client trails the market by 1.48 percentage points per year, mainly because of trading costs. "Investors hurt themselves with their trading," says Odean.

WHICH IS RIGHT FOR YOU?

So now that we've fleshed out the weaknesses of both stocks and funds, which of the two works best for you? Below are some guidelines to help you decide which camp you belong in, plus suggestions on how stocks can complement a fund mix and how funds can enhance a stock portfolio.

Invest in funds if...

...you have better things to do with your life than research your investments. If the idea of firing up a PC and spending a few hours screening on a CD-ROM or poking around stock research sites on the Internet has all the appeal of a root canal, you're probably a fund person. Fact is, selecting and keeping track of stocks is serious work, and if you're not willing to put the time and effort into choosing stocks--at least a few hours a month--then you're better off paying a fund manager to do the job for you. Of course, with some 2,700 stock funds clamoring for investors' money, you will still have to put some work into choosing funds that will churn out competitive returns over the long haul. But funds certainly don't require the careful monitoring that stocks do--especially if you buy an index fund that mechanically tracks a market average.

If you're worried about tax liabilities, consider the Schwab 1000 fund (800-435-4000), an indexed portfolio that invests in the 1,000 largest U.S. firms but offsets gains in some of its holdings with losses in others to avoid giving shareholders taxable gains. Since its 1991 inception, the fund has never made a capital-gains distribution. Other tax-efficient funds that minimize taxable payouts by limiting trading and matching losses with gains include Evergreen Tax Strategic (800-343-2898) and three Vanguard portfolios, Tax-Managed Capital Appreciation, Tax-Managed Balanced and Tax-Managed Growth & Income (800-851-4999).

...you typically invest small sums of money regularly. With their low minimum initial investments (typically $1,000 to $3,000) and even lower hurdle for subsequent deposits (usually $50 to $250), funds are ideal for salting away small amounts of cash on a regular basis--what's known as dollar-cost averaging. (That assumes, of course, that you choose funds that do not charge sales commissions.) Buying individual stocks in amounts of, say, $250 isn't economical since even razor-thin online brokerage fees would drive commissions to 8% to 12% of the value of your investment. In fact, unless you're willing to commit at least $5,000 at a time to a single individual stock--or better yet $10,000--you're probably better off with a fund (unless you are buying stock directly from the company through a DRIP or direct-purchase plan). Otherwise, brokerage commissions and other transaction costs become almost punitive.

...you want to diversify into international securities. Despite the recent carnage in emerging stock markets, history shows that over the long term, keeping 10% to 35% of your equity holdings in foreign stocks can lower the volatility of an all-U.S. portfolio. And the easiest way for most individual investors to add international flavor to their stockholdings is through funds that invest in foreign stocks. Quite simply, choosing individual foreign shares (even those that trade on U.S. exchanges), tracking the business conditions of global markets and following currency exchange rates is an exercise beyond all but the hard-core stock junkies. Funds are far and away your most convenient passport to foreign markets.

...you're looking for a complement to your stockholdings. Even if you are pretty much a confirmed stock investor, chances are that funds could play a useful role in your portfolio. For example, if you feel comfortable picking blue-chip stocks on your own but don't want to take the risk of delving into the unfamiliar waters of smaller stocks by yourself, then a fund is the way to go. Conversely, if you've loaded up with highly volatile technology stocks, adding a large-cap value fund that buys beaten-down blue chips can cut down the risk of your overall portfolio and smooth your ride through bumpy markets. Dell Computer, for example, lost 52.9% in 1993, before soaring 81.2% in 1994 and another 68.9% in 1995. The average large value mutual fund earned 13.5% in 1993, which would have at least cushioned the blow of your Dell loss--and possibly given you the willpower to hang on to the stock long enough to benefit from its recovery.

go with stocks if...

...you enjoy doing your own research. If you think that you've got a talent for analyzing companies and ferreting out those whose stocks are poised to prosper long term, then you might as well save the 1% to 1.5% or so you would pay a portfolio manager and pick individual stocks yourself. Investors who decide to go this route, however, will probably want to assemble an arsenal of analytical and research tools. If you prefer getting your information on paper, consider subscribing to the Value Line Investment Survey ($570 for a weekly subscription), which provides reams of stats and brief analyses, updated every 13 weeks, on 1,700 publicly traded companies. This publication is also available free at many large public libraries.

You can go further by using digital sources. For example, Morningstar's Stock Tools lets you screen for stock picks among 7,800 companies using as many as 150 criteria. Value Line also offers a CD-ROM version of its print service that expands its stock coverage to 5,000 stocks and allows for heavy-duty screening. But neither is cheap. Value Line charges $995 a year, for which you can get weekly updates from its Website, while Morningstar charges $675 a year if you opt for monthly updates, $375 for quarterly; both by mail. For free data sources, start at a Web search engine like Yahoo! Finance (quote.yahoo.com) or Excite's Business and Investing by Quicken site (quicken.excite.com). There are dozens of high-quality low-cost and free sites on the Web. A few of our favorites: StockMaster (www.stockmaster.com), Wall Street Research Net (www.wsrn.com) and, of course, Money.com (money.com).

...you want more control over when you pay taxes on gains. As we've seen, with mutual funds the manager decides when you get taxable gains. With stocks you decide how to manage gains and losses to minimize your tax bill. If you can hold off selling a winner until you've owned it more than 18 months, for example, your capital gain will now be taxed at a maximum rate of 20%. On the other hand, if you own a stock that's dropped in value and that you've decided is a loser, you can sell, take the loss and use it to reduce your taxable gains in other stocks (or funds).

...you own a lot of your own company's stock. Thanks to your 401(k) or an employee stock-option plan, you may own a considerable amount of your employer's stock. And you may not have as much leeway about when to sell that stock as you do with other shares. In the case of 401(k)s, for example, many companies provide their matching contributions in the form of company stock, often with the proviso that the stock can't be sold unless you leave the company.

While you certainly don't want to turn away free stock or options, they do present a certain risk--namely, if your company's prospects turn sour, your portfolio's value could drop at precisely the moment your job becomes more tenuous.

So if a significant portion of your portfolio is invested in your employer's stock--say, 10% or more--you could consider reducing that risk by buying stocks that will zig when your company zags. If, for example, you work for a computer software firm, you might want to buy some stocks whose fortunes don't rise and fall along with those of the technology industry, such as shares of consumer-products companies or pharmaceutical firms.

...you've got special insight into certain types of stocks. Even if mutual funds make up the core of your portfolio, there are several reasons you may want to round out your fundholdings with individual stocks. If you work in the financial services or tech industry, for example, you may think you have an insider's knowledge of which companies offer the products and services that will allow them to dominate their industries in the years ahead. And while most investors are probably better off stepping into the often risky territory of small-company stocks through mutual funds, there may be certain instances in which you feel comfortable taking on the risk of buying small-cap shares. For example, you may be familiar with a small company because you do business with it or use some of its products. In that case, you could consider buying in when the company is still in the fledgling stage in the hopes of riding it to big gains.

One parting thought to bear in mind when it comes to individual stocks: No one buys a stock because they think it's going to go down, but that certainly happens. Last year, finance professor Odean published an extraordinary research paper called "Do Investors Trade Too Much?" (You can read it on the Internet at www.gsm.ucdavis.edu /~odean.) Analyzing the trading activity of 10,000 discount brokerage customers from 1987 through 1993, Odean found that the average stock these investors bought underperformed the market by 2.7 percentage points in the next year. The average stock they sold, meanwhile, went on to outperform the market by 0.54 points over the next year.

Even the vast majority of professional money managers fail, year after year, to beat the market. Knowing that these experts lose so often, you need to be honest about your own odds of winning.

Reporter associate: Pat Regnier