In comments on my past two blog posts, two different commenters have taken issue with my advice to beginning investors to buy mutual funds. Let’s look at the costs and benefits to understand why this might make sense. I am assuming that a savings account, Canada Savings Bond or GIC isn’t an option, such as when beginning a long-term investment plan. Everyone has to start at the beginning, so we’ll assume a beginner investor, although that could mean a woman or a man anywhere from 20-something to mid-forties.
What options can a beginner investor consider? Possibilities include:buying a business, stocks, real estate, limited partnerships, mutual funds, ETFs, structured notes, variable annuities (seg funds). Many structured notes actually aren’t available to novices, as hedge funds are not. Buying a business or real estate directly usually involves onerous debt (at least for a novice), so we’ll exclude those.
What should a beginner investor look for in an investment? The first criteria depends on the person’s goals, but it should probably produce some form of learning from experience. A market linked GIC or a structured note wouldn’t achieve this goal because they sheild the investor from experiencing their own reaction to volatility. A real estate limited partnership should usually be avoided due to the massive risks, but it also shields investors from the responsibilities and risks of owning property. The second criteria would be that it is accessible with a small initial amount. This rules out most limited partnerships, structured notes and most individual stocks.
The most important criteria should be cost. This is what separates the remaining choices. Variable annuities (seg funds) are very expensive to own and should only be used for their unique features, which are generally more suitable for elderly people. Individual stocks, including ETFs, can be very expensive to buy, especially through a full service broker. Even a discount broker generally costs about $25 per trade (unless you have over $50,000 or trade frequently, which disqualify the novice investor). A mutual fund generally costs nothing (or very little) to buy and sell. The second aspect of cost is the recurring cost (MER). Individual stocks cost nothing, ETFs generally cost between 0.15% and 0.50% per year, and mutual funds generally cost between 2.0% and 2.5% per year.
The benefit of mutual funds and ETFs over individual stocks is the built-in diversification. Each fund might own shares in 50 – 200 companies, which can be accessed with a single trade. A stock trading account is typically more focused, with shares of 10 – 30 companies. The downside to this diversification is that a fund can perform worse (or better) than a given stock. Most investors seem to consider that unknowable and assume that the performance will be equal before fees (ie. costlier investments will perform worse).
Here’s some example numbers to clarify. A beginning investor decides to save $50 twice a month and wants to invest in the stock market. It is obvious that paying a $25 commission each time would be untenable. It would be possible to accumulate cash and invest in an ETF only once a quarter ($100 in commission, plus $1.20 in MER). But to maximize learning from experience, an investor can buy mutual funds with each $50 deposit (plus $12 in MER). The second year will cost more in MER for each fund, but the higher MER won’t outweigh the commission until the investor has accumulated between $10,000 and $15,000. But by the time he has $30,000, he should be able to invest in individual stocks with adequate diversification to further save money by paying no MER at all.
I will add only a single note on active vs. passive. It is possible to buy ETFs that incorporate active management and mutual funds that track an index. It is also possible to mostly replicate an index using individual stocks. So I don’t believe the preference for active or passive needs drive the choice between mutual funds, ETFs and individual stocks.
How did you gain experience when you began investing? What’s the best way to learn without getting in real trouble?