Equity mutual funds pool together money from many investors and invest in a group of stocks. This process in theory is supposed reduce risk to investors especially the risk of owing individual stocks which can blow up. However that is not always the case. Mutual funds also have high risks and they are not necessarily the best option for investors to reduce risk or earn higher returns.

Investing in individual stocks is considered to be higher than investing in a mutual fund. At least that is the theory. But in reality stocks have many advantages than mutual funds. Investors able to afford a good amount of money can easily build a portfolio of high-quality stocks and earn better returns than mutual funds while reducing risks.

With that said, the following are some of the advantages of individual stocks over mutual funds:

1)When a mutual funds becomes too large in size, the fund’s ability to invest efficiently deteriorates. As a fund becomes highly popular more and more investors pile in leading to a big bulge in investment assets. In this scenario, the fund may not be flexible and nimble at it was when net assets were much smaller. So investing in such funds is not a wise move.

2)Mutual funds limit the ability of an investor customize their investments. For example, if a customer wants to avoid a certain stock like a Facebook(FB) or Amazon(AMZN) for whatever reason, it is not possible to exclude that firm from a mutual fund. This is because the ultimate control of how investors’ money gets invested is decided by the fund company and not an investor.So an investor loses the freedom to say pick and choose as they wish and instead is at the mercy of the fund company.

3)In terms of tax efficiency, stocks are much better than mutual funds. With a mutual fund, an investor pays taxes on any annual distributions by the funds and again when he sells the funds. So by trying to reduce risks, a fund investor actually increases the definite possibility of paying much higher taxes.In addition, even when a fund loses money an investor may owe taxes.

4)Tax loss harvesting – Mutual funds limit the ability of an invest to harvest losses for tax purposes. A mutual fund manager can harvest losses within a fund, but an investor can only harvest losses when the fund is down. In a rising market this benefit is lost quickly.

5)As mentioned earlier, an investor in a mutual fund completely loses control of their investment. By building a portfolio of stocks an investor can decide to sell a stock which has positive growth and then pay taxes on the capital gains. This power is lost when going with a fund.Some manager running other people’s money decides what to run and what to sell. So in summary, an investor can decide when to sell a stock at a gain and pay capital gain taxes due.Depending on an individual’s tax situation they can decide when they want to realize a gain.

6)Mutual fund investors can be adversely affected by their fellow investors. In a highly volatile market, if investor panic and sell then a fund manager may liquidate stocks at a gain or loss. An investor who wants to simply sit out the volatility can’t do that without enduring the loss caused by other investors. With individual stocks there is no such worry. Mutual funds can be considered as “socialist” type of investment product where an investor ends up paying for the actions of some other persons. When we favor everything in life in a capitalist way, we should seriously think why we need to go for socialism in investing our hard earned money.

7)Trading – A mutual fund such as an open-ended fund can be bought and sold once per day. This limits flexibility. Stocks on the other hand can be bought and sold anytime the market is open.

8)Fees  – Many mutual funds charge high fees such as management fees, advisory fees, legal fees, 12-b1 fees to cover marketing expenses and a zillion other fees to effectively wipe out any advantage of owning a fund.When the market is up 5% and total fees add up to 3%, you are only earning a 2% return. This is at least not an awful scenario. The really bad case is when the market is down and the fees continues to be deducted from the funds’ assets. So even when the market is down say 10%, fund fees will be automatically deducted from the fund.

9)Some funds charge loads(fees) upfront or when selling a fund. This reduces the amount that gets to work for an investor. No such problem exists for individual stocks.

10)Income – With individual stocks it is possible to build a customized portfolio of dividend stocks for example and receive cash dividends each quarter to spend or do whatever one wants. This is not possible with a fund. The distribution of dividends or capital gains from a fund depends on the fund company.

Source: The Case Against Mutual Funds by Matthew Young, Young Investments and self opinion.

Dollar Cost Averaging (DCA) is an investment strategy by which you invest little by little in each period instead of a lump sum in one shot. By investing small amounts say each month over many years one can reduce volatility and also the risk of heavy losses. Over time small amounts tend to benefit from the effect of compounding also. Similar to compound interest in the banking world, overall growth of amount invested over time will be higher with DCA as capital invested compounds over many months or years.

I recently across an article demonstrating the power of Dollar Cost Averaging by Frank Holmes of U.S. Global Investors. While he uses the below example to show the benefits of DCA there are two critical flaws in his demonstration. From the article:

What is does require, though, is discipline. Put a long-term plan in place and let compound interest work its magic.

I’ve shared this chart with you before, but I think it’s worth sharing again. It shows a hypothetical initial investment of $1,000 in an S&P 500 Index fund in March 2009. Ten years later, after regular monthly contributions of only $100, the value of that initial investment grew at an annualized 12.96 percent to more than $26,385. Investors who had the discipline to stick with this plan and reinvest the dividends were rewarded handsomely.

Remember, the illustration above includes only the period during the 10-year bull market, and there’s no guarantee that the good times will continue.

But with dollar cost averaging, some of the guesswork involved in market timing is eliminated.

Remember, the illustration above includes only the period during the 10-year bull market, and there’s no guarantee that the good times will continue.

But with dollar cost averaging, some of the guesswork involved in market timing is eliminated.

Source: Retire Happy With Dollar Cost Averaging, U.S. Global Investors

I think there are two issues with the above example. One is cherry picking the time period. Selecting the lowest point of the Global Financial Crisis (GFC) of March 2009 as the starting point for the above chart is not the ideal way to prove the benefits of DCA. Hardly any retail investor would have had the foresight to start a long-term investment in March 2009 when it seemed like a depression was about to begin. Had the selected starting year was 1999 the result or the annual yield of the above chart would have been entirely not so great to say the least.

Another related issue is that the annualized return of 12.96% is very high because March 2009 was the starting point. Again achieving an average annual return of 13% is not an easy task. By simply selecting the bull market as the time period the annual return is high. This may give some investors the false idea that DCA an yield double digit returns easily.

The correct way to demonstrate the power of DCA is to use a time period that is long enough to include both bull and bear markets and not just a bull market alone. In addition, choosing the trough of a great bear market as the starting point also artificially inflates the benefits of DCA.

Regardless the key for investors to remember is that the best and easy way to save for retirement or some other long-term financial goal is to invest regularly even if it is a small amount and let the power of compounding do the trick. Investors should not fear bear markets and stop their periodic contributions.Instead it is important to have patience and focus on the long-term goal.