Newbie Investing Theory Question

[DeathDonkey]

I am having a hard time wrapping my brain around this concept, so I'll try and explain my confusion, and maybe someone can point out where I am mistaken...

It seems from recent threads I've read that everyone agrees 95% of mutual funds do not beat, or barely beat the overall market. From that, the advice is to often look to index funds as a relatively safe way of investing with low fees and a proven track record for success.

Why then, would someone invest in invididual stocks at all? By doing so, you are basically saying "I can do better than a mutual fund manager and beat the average" aren't you? If you truly can do this, why aren't you a large mutual fund manager yourself?

How can an individual investing in various individual stocks have an edge? Is he simply "getting lucky" to beat the average, or if not, why don't mutual funds - run by "experts" - perform at an equally high level every single year? Why this juxtaposition?

Thanks,
DeathDonkey

[hedgeyerbets]

Some answers...
(1) Mutual fund managers manage a LOT of cash. It's a lot harder to find, say, 5 billion dollars worth of good investment ideas than it is to find 100k worth. Buying enough stock to fill a mutual fund either means that you are restricted to mega cap funds, or you have to be content to have to pay a few percent more and sell for a few percent less (b/c you will move the market by making huge transactions). Look at the top holders for a couple of big stocks. Fidelity, for example, is one of the top 10 holders for a frightening amount of stocks.
(2) Even without these disadvantages, it remains tough to beat the market. There aren't many stocks that are obviously mispriced by a large amount. Unless you have done a lot of research and think you have some edge on the market at large, it is NOT worth buying individual stocks.

[Sniper]

The market rewards the smart and nimble... mutual fund managers may be smart (not in all cases), but they are anything but nimble!

You can't turn a battleship on a dime, but you can turn your raft... just dont get swamped by the battleships wake and you'll be fine [img]/images/graemlins/wink.gif[/img]

[DesertCat]

Actually I think most mutual funds do beat the market, before their fees. The math is something like the typical actively managed fund is charging between 1.5% and 2% per year, and only beating the market by 1%.

Another reason is that a mutual fund's objective isn't necessarily to beat the market, it's to keep and accumulate investor funds. It's really hard to outperform other funds and indexes significantly, but if you buy the same stocks as the S&P 500 and other funds you are guaranteed not to trail the market by much, and you can keep your investors (mostly) happy. So many large funds are (supposedly) index funds under the hood.

An example of this is the market timing controversy of last year. Funds were allowing big investors to buy shares each day after close, which actually hurt their fund returns (and esp. hurt returns of other investors in the fund who weren't market timing). But the more money the fund has invested, the more fees they make.

Mutual funds own too many different stocks, far more than they can reasonably understand. When you are putting money into a hundred positions, ten might be really great ideas, the rest are filler. They have to diversify for several reasons, but large funds esp. can't buy too much of any single stock.

This can cause problems because investors can pull their money out any time they want, and they get almost instantaenous updates on performance. So in a market downturn, the fund may be forced to sell it's positions to raise cash for people leaving. This causes their positions to fall, the fund to fall, and then more people want out.

So a fund can be forced to sell it's best ideas when they are cheap, and may not get more money to buy them back until after they go up again.

These are all reasons people setup private investment partnerships (sometimes called Hedge funds). They can restrict investors from redeeming funds except with significant notice (no trading in and out). They don't have to give daily updates. They can and do get compensated for delivering high performance. Their competitors don't know what they are buying (and vica versa). They can be more focused and less diversifed, and buy about anything they want.