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No. of Recommendations: 9
1. Stops are not available on Mutual Funds:
As millions of investors realized when the internet bubble popped, Mutual Funds can lose you money just as quickly as individual stocks. Without stop-losses in place, you are risking unlimited losses. (or at least down to zero)

2.- Options are not available on Mutual Funds:
Buying protective Puts can insure a stock investment against loss. This strategy is especially valuable during earnings season when good stocks are destroyed by the market for no good reason. What is your downside insurance with a Mutual Fund? There is none.

If you want a Mutual Fund, my advice is to load up on GE. There you have an individual stock that is really a Mutual Fund, due to diversification. Additionally, based on the two reasons above, GE is far less risky to your portifolio.


Hey Joe,

I disagree with the premise stated in the subject heading, and I do not think you have supported your thesis with points one and two above. And I have some comments about the GE idea. Let's look at your assertions first.

Point One: "As millions of investors realized when the internet bubble popped, Mutual Funds can lose you money just as quickly as individual stocks. Without stop-losses in place, you are risking unlimited losses. (or at least down to zero)."

I'll ask you to provide the name and ticker of ANY mutual fund that declined to a NAV of zero without any warning to its shareholders. I'm not talking about funds that were shuttered suddenly due to regulatory inquriries or some other such problem. I'm talking about a true "mutual fund" (I believe the legal definition is that it must hold at least 12 stocks, something like that), which has a positive value on one trading day, and which drops to zero (due to all its stocks plunging simultaneously to zero, or being delisted from the stock exchange, or whatever) on the next trading day. Or even, from one week to the next!

That happens to *individual* stocks all the time, whether they are internet/tech stocks or in some other industry. But the scenario you described -- a mutual fund dropping to zero -- requires that at least a dozen different companies go belly-up simultaneously. I never heard of a fund with that kind of portfolio, but even if there ever were such a fund, it surely is the exception, NOT the rule.

If you are trying to trade mutual funds based on INTRA-DAY changes, you are out of your mind (no offense!). But let's say you simply want to prepare yourself to sell a fund because its value has declined by X%, as one might do with a stock. Well, you might be able to hit that percentage point for a "stop loss sale" fairly closely, by making a reasonable estimate of its end-of-day NAV, based on the underlying stock trends in place at roughly 3:45PM EST.

Morningstar will tell you the top 25 holdings of any mutual fund. You can enter those stocks into a portfolio somewhere (M* or Yahoo or wherever), using their relative weight as reported by the mutual fund. Then let the portfolio tool tell you what kind of rise or fall has happened at any given moment. Naturally, you will want a service that does not have a time delay like Yahoo does, so this might require paying for a premium service somewhere or other.

But you'd have a good idea of how that fund would do, with 15 minutes to contact your broker and sell the fund.

Now, this tactic would not work real well with funds that have big portfolios (like, 100 stocks or more). Chances are, those top 25 holdings, described above, might comprise only 20-30% of the whole fund, and might therefore not tell you very accurately where its NAV would end up after 4PM.

But wait -- if you have a mutual fund with that many stocks in it, it should be statistically unlikely for any individual sector or industry to kill the entire fund all at once. And that is the underlying flaw in your assertion. The only way it could be true is if a mutual fund were extremely concentrated, with very few stocks, and all of them in related companies. If such funds exist, they are very rare.

Heck, even the "sector" funds that I own do not have that amount of concentration. I have two REIT funds, and they tend to move in sync with each other -- but not always! I've got two tech-oriented funds, and the same applies to them. If you spread your money out among good companies, represented by stocks held in well-run funds, you don't have to think much about stops. Thus, the only kinds of trends you need to look at provide clues weeks, months or more in advance, at which point you can shift assets around -- and nowhere near a value of zero!

One of the keys we stress around here is diversification. Joel claims not to believe in it, but he does not invest the same way most of us do. And I think it's valuable for the "typical" investor. If you have a portfolio that is adequately split by company size, valuation, sector, geography, asset class, and other factors, then you are really, really unlikely to ever see your nest egg killed all at once.

Back in the dot-com era, the old partners "Fear and Greed" really ran the show a lot more than usual. In fact, if you look the phrase up you will find that period used to illustrate the concept: http://www.investopedia.com/articles/01/030701.asp

"So often investors get caught up in greed ("excessive desire"). After all, most of us have a desire to acquire as much wealth as possible in the shortest amount of time. The Internet boom of the late 1990s is a perfect example. At the time it seemed all an advisor had to do was simply pitch any investment with a ".com" at the end of it, and investors leaped at the opportunity. Buying activity in Internet-related stocks, many just start-ups, reached a fever pitch. Investors got greedy, fueling further greed and leading to securities being grossly overpriced, which created a bubble. It burst in mid-2000 and kept leading indexes depressed through 2001...

This get-rich-quick mentality makes it hard to maintain gains and keep to a strict investment plan over the long term, especially amid such a frenzy, or as the former Federal Reserve chairman, Alan Greenspan, put it, the 'irrational exuberance' of the overall market...

...Just as greed dominated the market during the dotcom boom, the same can be said of the prevalence of fear following its bust. In a bid to stem their losses, investors quickly moved out of the equity (stock) markets in search of less risky buys. Money poured into money market securities, stable value funds and principal-protected funds - all low-risk and low-return securities. In fact 2002 saw the largest amount of outflows, about US$40 billion, from the equity markets since 1988, a year after one of the worst stock market crashes in history, and a record $140 billion flowed into the bond market.

This mass exodus out of the stock market shows a complete disregard for a long-term investing plan based on fundamentals. Investors threw their plans out the window because they were scared, overrun by a fear of sustaining further losses. Granted, losing a large portion of your equity portfolio's worth is a tough pill to swallow, but even harder to digest is the thought that the new instruments that initially received the inflows have very little chance of ever rebuilding that wealth."


SO: worrying about stop-loss tools with mutual funds seems to me an inappropriate application of the "fear" concept to a type of investment vehicle where it simply is not appropriate.

Point Two: "Buying protective Puts can insure a stock investment against loss. This strategy is especially valuable during earnings season when good stocks are destroyed by the market for no good reason. What is your downside insurance with a Mutual Fund? There is none."

Most of the same counter-arguments apply here. If you own something like a DJ30 index fund, well, yeah you could see it drop by a couple of percent if one of the big players has bad numbers. But not always. One major function of an index is to form a collective valuation, so that no single company ruins things for everybody.

Again, it is in concentrated, sector-specific funds where one would be more likely to see the kind of risk you are talking about here. Is there a fund holding just 15 stocks, all from microchip manufacturers? I don't know, but that's the kind of fund that might bomb on a bad report from Intel, AMD or Texas Instruments -- just to choose an example.

But there just aren't very many funds with that kind of construction! The bulk of the thousands of diversified funds out there invest based on geography, market cap or investment style, often in some combination. Those characteristics do not lend themselves to issue-specific risk, like one company's earnings report.

Anyway, the concept you described above is arbitrage. Buying put options, while holding a long position in a stock, is a complicated way of hedging your investments that only works if you are really good at it. By contrast, the way a person hedges in a mutual fund portfolio is, as I said earlier, by diversification. Own some other asset class that zigs whenever stocks zag. Own one fund that has interest-rate-sensitive stocks, and another fund with stocks that are impervious to interest rates.

Simply look for the biggest variables that might push the overall market in one direction or another, and own positions on both sides of the divide. Heck, one should do that with a stock portfolio, too.

Mad Money guru Jim Cramer talks about stocks all the time, and I agree with his basic approach: buy stocks in good companies for which there is a catalyst for upward movement in the stock price. Just find them by your own homework, perform due diligence to eliminate any risk that might lurk in unknown threats to that company's business, and then buy the stock and hold it until its valuation reaches saturation.

He never talks about arbitrage, even though he used to run a hedge fund. He only looks for stocks to hold in long positions, with all risk management provided by the diversification of the total portfolio. And for the record, this master of hedging advises that small investors ($10K or less) should buy mutual funds, rather than trying to play the market!

The stock-as-Mutual-Fund idea: "If you want a Mutual Fund, my advice is to load up on GE. There you have an individual stock that is really a Mutual Fund, due to diversification. Additionally, based on the two reasons above, GE is far less risky to your portifolio."

I don't know if you're aware of this, but what you're describing is sort of the notion behind Berkshire Hathaway. The problem with GE is that it has had a very serious problem trying to escape a narrow trading range for a long time.

GE stock is trading today at roughly the same price that it did in early 2002. As others have pointed out, even sluggish indexes are outperforming it over the past five years. And Berkshire Hathaway (BRK-A) is beating all of them: http://finance.yahoo.com/q/bc?t=5y&s=BRK-B&l=on&z=m&q=l&c=GE&c=%5EGSPC&c=%5EIXIC

And can one beat all those with a relatively low-risk mutual fund? Sure. The Oakmark Balanced Fund (OAKBX) is extremely tame -- but it beats Berkshire Hathaway (and thus, the indexes) over the past 5 years: http://finance.yahoo.com/q/bc?t=5y&s=BRK-B&l=on&z=m&q=l&c=OAKBX

So, on a fairly consistent five-year basis, OAKBX beats BRK-A, which beats the Nasdaq, which beats the S&P500, which beats GE.

So let's see... you've got the *stocks* of two massive conglomerates, plus two of the broader *stock* indexes out there, and none of them can match this meek, mild-tempered moderate allocation mutual fund. So tell me again, how is a fund like OAKBX inherently riskier than a stock? ;-)
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