You have defined a target asset allocation. How should you now build your investment portfolio? By investing in non-diversified, individual assets? Such as common shares of Apple or Tesla. Or is it wiser to invest via well-diversified investment products? Such as mutual or exchange traded funds.
All that and more in Episode 28 on the Wilson Wealth Management YouTube channel.
“Should you invest in individual assets?”
This is a “build your own” portfolio approach. You analyze potential investments across various asset classes and subclasses. Then invest in securities deemed “best in class” to fill out your target asset allocation.
In theory, as you only own the “best” investments in each class, maybe shares of Apple, Google, or Netflix for equities, you should create a strong portfolio. One that outperforms your benchmarks.
Whereas if you bought a S&P 500 index fund, you purchased 500 different companies, whether you want them or not. Great to hold Facebook, Apple, Netflix, and Google in the fund. But you also “own” Norwegian Cruise Lines, Carnival, and United Airlines. Companies whose shares plummeted in 2020 due to COVID.
By owning the “FANG” stocks and avoiding the cruise lines, you would have beat the index return.
Makes a lot of intuitive sense. And the main marketing tool from active asset managers.
This is a doable approach if you have the critical mass of capital to diversify across your target asset allocation. If you are a High Net-Worth Investor, a “build your own” portfolio can make sense.
It may also be a good approach for active traders. Who create non-diversified portfolios and like to jump in and out of specific positions. Or for those who like to tactically invest or engage in market timing. Utilizing a portfolio of individual securities may be a positive for these investors.
Okay, that sounds quite easy. Investing in individual securities is definitely the way to invest.
But it is not that easy in practice.
“What are the potential problems with investing in individual securities?”
While doable, it may not be practical for many investors.
Retail investors may lack the critical mass of capital to manage this approach effectively and efficiently. Though, often smaller investors can find cost effective ways to help acquire common shares. Dividend Reinvestment Plans tend to be very useful.
Can you manage investment fees? If you need a minimum of (say) 30 equities, 15 bonds, and some cash, transaction costs can add up over time as you build or adjust positions. It is much more cost effective to invest $100,000 at a time in an investment, as opposed to $300.
You may also trigger taxable events in buying and selling individual securities.
Can you consistently pick the winners? There are a lot of asset classes and subclasses. With a myriad of individual investments in each. How do you find the “best”? An issue we will cover in future episodes.
Can you manage the opportunity cost? The time required to monitor and amend the portfolio. You cannot simply buy a stock and forget about it. Quality changes over time. Better investments may emerge. If you have a portfolio of 50 assets spread globally, that may require significant time. Do you have the spare time to deal with the portfolio? Or hire someone who does?
Can your properly diversify your portfolio with 50 assets? Investment theory says yes, but you need to do a good job combining asset correlations to create an optimal portfolio. The less securities, the more challenging it will be.
All of these are potential disadvantages in individual securities. But the difficulty in optimally diversifying may be the biggest negative. The greater the number of investments required to diversify is what causes problems in the other areas. With investment expenses, having to consistently find winning investments, and the ongoing time required to manage the portfolio.
As to why you need a “wide variety of investments” to properly diversify, please read, “Introduction to Diversification”, “Diversification and Asset Correlations”, “Asset Correlations in Action”, and “A Little More on Diversification”.
If you prefer audio/video format, please check out, “Episode 16: What is Diversification”, “Episode 17: Asset Correlations”, and “Episode 18: Correlation Obsession”.
“What are investment funds?”
What are the common types of investment funds?
What are open-end and closed-end mutual funds? How are they similar? How do they differ?
What about exchange traded funds (ETFs)? How do they compare to open and closed-end mutual funds?
And hedge funds? Is that something retail investors typically use?
If you want additional detail on these different investments, please read “Investment Funds”.
“What are some of the pros and cons of investing via funds?”
Unsurprisingly, many of the potential disadvantages associated with individual securities are positives in investment funds. Investors do not need much money to invest. Well-diversified products. Many are low-cost for investors. Actively managed funds are run by investment professionals. Investor portfolios will have very few investments versus an individual approach. Much less time commitment to monitor.
And the advantages of associated with individual assets tend to be potential concerns with funds. You may not own exactly the securities you want. If you passively invest, you will own the entire index. If you invest in actively managed funds, there may be some fund holdings you do not like.
This episode provides more of a high level comparison with the funds available for investors. We will dig much deeper into investment funds in upcoming episodes. Especially, the potential advantages and disadvantages of open-end mutual funds and ETFs versus individual securities. And in comparing mutual funds against ETFs as investment vehicles.
