This is a guest article by Barbara Friedberg, editor-in-chief of Barbara Friedberg Personal Finance. Barbara holds an MBA in finance, a BS in economics, and an MS in counseling. In addition to writing, Barbara is a portfolio manager and a professor.

“The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.” — Warren Buffet

The greatest investor of this generation is espousing a fundamental investing maxim. Keep it simple and you will prosper. In fact, research shows that the more investing trades one makes, the worse their return.

How I went from funds to stocks — and back to funds

I started out terrified of investing in stocks either individually or in funds because of the crash in 1929. I thought that I would lose all my money if I invested in stocks of any form. That was before I had much investing knowledge.

History shows that stocks have outperformed bond and cash investments over the long term. Throughout the twentieth century stocks averaged 9.0%, with plenty of ups and downs along the way. Does that mean they will always perform that well? Absolutely not! In fact, the ten year return of the Vanguard Total Return Stock Index (VTSMX), effective July 27, 2010 is only an annual 0.05%. During that time period, cash and bond investments outperformed stock investments. That’s a far cry from the 9.0% per year average return.

After studying historical returns, I decided to invest in a stock mutual fund through my workplace retirement fund. I had 75% of my contribution allocated to a broad-based stock fund and 25% to a cash investment with a fixed return.

Over time, which do you think performed the best? If you guessed the stock fund, you were correct. But I was still happy to have the fixed return fund since it tempered my portfolio value when the stock market returns moved lower.

Buoyed by the performance of the stock fund and motivated by my passion for investing, I decided to investigate investing in individual stocks. I read every investing resource I could get my hands on and came across a non-profit organization designed to teach a fundamentally based stock research methods, the National Association of Investors Corporation. Their tools enabled me to research and analyze individual companies, look at their financial ratios, compare their valuation metrics and make a reasoned investment decision.

It was so much fun for me: the hours of reading annual reports, comparing return on equity, PE ratios, and more with similar companies. Of course graphing the metrics over time gave me a visual view of the direction of the companies’ sales and earnings.

During this period, I surpassed the benchmark returns by a couple of percentage points. I also earned an MBA in finance and got a job as a portfolio manager.

Investing in individual stocks is a lot of work!

Not only does the investor need to decide when to buy, but she must determine when to sell. That’s two opportunities to make a wrong decision. Furthermore, every investor has losses, and some of them are large. One of my worst stock losses was a decline of over 50%. Fortunately, I had the time and knowledge to devote to investing in individual stocks. I also had a temperament that is suited to remaining calm during the inevitable volatility of the investments.

Over the last few years, I have sold most of my individual stocks opting for a diversified portfolio of index funds.

Why I prefer fund investing to individual stock investing

The efficient market hypothesis supposes that in most cases it is difficult to beat the return of the overall stock market. There are many exceptions, but overall, holding a diversified portfolio of index funds or exchange traded funds is an efficient way to match the historical returns of the stock market. In fact, very few professional mutual fund managers beat the average stock market returns over time!

Advantages of investing in stock mutual funds over individual stocks

• Diversification
• Low cost
• Less research and maintenance time
• OUTPERFORM most actively managed funds

Invest in individual stocks if you:

• Enjoy the research and analysis necessary to choose individual holdings
• Have enough education to read a balance sheet and understand financial ratios
• Have sufficient time to devote
• Can tolerate the excess volatility above and beyond that of the overall market

Editor’s note: I (Flexo) invest mainly in stock mutual funds such as VTSMX but I occasionally dabble in individual stocks beyond my company stock purchase plan. I’ve lost money doing this — on paper, since I have not locked in any losses by selling. I still believe the companies I’ve invested in are good companies and will eventually see their stocks increase beyond my purchase price, and some have already. Do you invest in individual stocks or mutual funds?

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Last week I wrote about lump sum investing vs. dollar-cost averaging, voicing the opinion that in most cases, if a lump sum is available, it’s a better choice in the long run. But how do you invest that lump sum?

It’s great that the financial media has been encouraging young people to start thinking about investing as a part of becoming aware of financial responsibilities and future needs. The general consensus is often to put as much as possible into the stock market for the best chance for long-term growth, and without much further thought, an index mutual fund like VTSMX is the vehicle.

That’s great for a quick start, and it’s better than not doing anything at all, but when these choices are automatic, you’re not really in control of your finances. Walter Updegrave, senior editor of Money Magazine, suggests asking yourself several questions that get to the heart of an investor’s needs and goals. The answers should determine how you should invest your money.

These suggestions are in response to a reader who asked Money Magazine how to invest $300,000 received as part of the sale of a home, assuming these proceeds are not needed to buy a new house. The strive to determine an investor’s philosophy, the true goal of these questions, is the same regardless of the amount to be invested.

The first question is significantly more important than the following two, but as you’ll see, questions two and three will have a significant effect on the success of question one.

Question 1: What am I investing this money for? Most people don’t think about their goals. The object, they may believe, is to just keep increasing their net worth. Money in a bank is great to have, but there’s no point to money unless it is being used for something, either now or in the future. A high net worth is not a goal, it’s just an intermediary step to achieving a real goal. Having investments worth $1 million (or $10 million, or $10 billion) is merely a milestone, not a destination.

Updegrave suggests determining the goal for just the immediate funds you have available, but I suggest looking broader if you haven’t already? What do you want to do with that money? Besides having enough to improve the quality of your life, do you want to improve life for the poor? Do you want to foster a wider appreciation for the arts? Do you want to own a baseball franchise? Will your money go to work building a school?

Once you’ve decided on a major goal or two, you can have a better sense of what your goal is for the amount you have available to invest today. Perhaps you can use it to get started on one of these goals, but perhaps you need a car to get around or you want to pay for your children’s college education.

Question 2: What investments do I need to achieve my goal? This is a more difficult question for the investing novice. Updegrave suggests keeping it simple by building your portfolio from just two index funds, one containing stocks and the other containing bonds. Adjust the allocation between asset types to suit your growth needs and risk tolerances.

You should have a time horizon in mind to help you determine your allocation. Without a time horizon, you will not know how much risk you can tolerate. Even the best plans often fail due to unforeseen needs, so your investments should be flexible, as well.

Question 3: What am I paying for my investments? Index funds simply match market index benchmarks like the S&P 500, so you would expect all index funds in the same category to provide you with the same gains each year. It’s not quite that simple; management fees eat into those returns, causing some funds to consistently perform better than others. The same holds true for managed (non-index) mutual funds. The solution is simple: given similar funds, choose the fund with the lowest fees.

Questions to ask yourself when investing, Walter Updegrave, Money Magazine, June 22, 2010

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Is dollar-cost averaging (DCA) a sound investing strategy?

In theory, dollar-cost averaging allows you to invest smaller portions of your money over a longer period of time, reducing the chance that you pay a price too high for any individual investment. If your ideal allocation calls for $50,000 to be invested in the stock market through an index fund like VTSMX, rather than buying $50,000 worth of the fund in one day in a lump sum, dollar-cost averaging spreads that purchase in equal amounts out over days, weeks, months, or even years to reduce your exposure to daily fluctuations of the market. By investing the same dollar amount each time, you buy more shares when the price is lower and fewer shares when the price is higher.

In other words, if you buy $50,000 of VTSMX on January 1 and the stock market crashes on January 2 without recovering for six months, you might kick yourself for not having the cash available to buy when the price of the fund was more favorable in the months your investment on January 1.

Many brokers allow you to dollar-cost average or invest in a lump sum. Here are a few current special offers.

• Recommended: ShareBuilder offers a $25 bonus
• Recommended: Scottrade offers $7 trades
• OptionsHouse offers 100 free trades
• E*TRADE offers 100 free trades
• Zecco offers 10 free stock trades

The only good reason for dollar-cost averaging is you may not have that $50,000 ready at one time. If you rely on investing only from money left over from your paycheck every two weeks, you don’t have a lump sum available. Those who do have funds available might have already missed out by not investing earlier.

Investing in the stock market as soon as possible with whatever money you have available, in order to form your ideal asset allocation, beats dollar-cost averaging in the long run. Dollar-cost averaging would leave your ideal allocation unfulfilled by leaving a larger percentage of your total assets in cash, uninvested.

Overall, the stock market trends upward, even at the company level if that company is healthy. If you buy individual stocks of a healthy company, the price should move in an upward trend over the long term. Dollar-cost averaging will never be able to make up lost ground compared to investing an available lump sum because you will, on average, dollar-cost average your way into higher prices.

While there may be exceptions when looking at your investment performance in the short term, especially in an environment where stocks are stagnant or declining, but as a long term investing strategy, dollar-cost averaging fails. Small instances of luck will eventually give way to major trends. So far, almost every experiment I’ve personally attempted has shown that I cannot reliably time the market as well as I want to. I almost always would have done better by just investing as soon as possible rather than sitting with cash.

Psychologically, however, dollar-cost average has a more important role. Spreading out the short-term exposure to any specific day’s stock price can make an investment in the stock market feel less risky. If you’d otherwise be concerned about your investments that might fall 1%, 5%, 10%, or more in one day, dollar-cost averaging can help allay those fears. If you have those fears, you may want to reassess whether you’re comfortable with the risk of the stock market in the first place.

Here are some links for thought:

• The Wrong Reason to Dollar-Cost Average
• Do Not Dollar-Cost-Average for More than Twelve Months
• The costly myth of dollar-cost averaging
• Nobody gains from dollar cost averaging analytical, numerical and empirical results

Please share your dollar-cost averaging experiences, concerns, and thoughts.

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