Investors typically think of their portfolio in one of two ways. Some select companies to invest in based on the fundamentals of the organization. Others choose mutual funds, which enable participation in the market without having to conduct all the research. Both can be very effective, but they are very different approaches.
Mutual funds. Let’s say you are the investor that wants to invest in mutual funds. Your best approach is to diversify among many asset classes. The beauty of this approach is that you can get into many types of stocks and no single company will break your portfolio. However, because you are so diversified, no individual company will significantly help your portfolio. So think of your returns as being smoothed over. Your highs will not be as high and your lows will not be as low. Most people like mutual funds for that reason.
Mutual funds also allow you to access many different markets across the globe. You can invest in a global real estate fund as well as a currency or commodity fund, and you can do this with very little money because many mutual funds have low investment minimums.
The real problem with mutual funds, especially in this current range-bound market (when the market goes up and down between a range; like 10,500 to 12,500 for the Dow), is that they tend to follow the market both up and down. Their portfolios are more general in nature and thus will follow the more general markets.
Individual stocks. While more risky, individual stocks can present more opportunity than mutual funds. However, you cannot diversify as much. If you want to get into currencies, commodities, or global real estate, it is more difficult, if not impossible. Here as well, the opportunity for success is as high as the risk of significant loss. Consider a portfolio invested evenly across ten stocks. One could go belly up, and if the other stocks did not change in value, the portfolio would have a big loss. On the other side of the coin, that same stock could double in value and significantly help your portfolio.
[See 3 Reasons to Hold Cash NOW.]
So here is the take away. If you want less volatility in your portfolio, invest in mutual funds, but utilize as many asset classes as you can. Look for funds that invest in the items noted above, like currencies, commodities, and global real estate, but also add global fixed income, emerging market stocks, and emerging market debt. Still further, add investments that could help to reduce risk, like long/short funds, absolute funds, and managed futures.
If you want to fully participate in the markets and can handle more risk, choose a portfolio of individual stocks. But have a strategy. Choose those stocks that have consistently increased their dividends, have had stable stock prices in good and bad markets, and have free cash flows (cash beyond their expenses). Look for companies that have great products used by consumers every day. If you want to dig a little deeper, choose those companies that have consistently increased sales each year. For that statistic, you may have to read their annual reports.
Making money comes with a price. You can either take the less volatile approach with mutual funds or put more work into developing a stock picking strategy. Both work, but they appeal to very different objectives.
Good luck and happy investing.
Kelly Campbell, CFP® and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Alexandria, Va. Campbell is also the author of Fire Your Broker , a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.