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Morningstar.com's Interactive Classroom

Course 309
Adding Stocks to a Fund Portfolio

Introduction

Fund investors may be put offby the idea of choosing stocks themselves. After all, many of them invested in funds precisely because theydidn'twant to do their own stock-picking. They want to keep their investing lives simple.

But the effort involved with investing in stocks directly can be worth it, for a few reasons.

Stocks Can Add Oomph

Over last last 10 years through Oct. 2012, Netflix has returned 33% per year on average. Try getting that kind of result from a mutual fund. But before you get too excited, you should know that Netflix stock would have returned much more had it not lost 60% of its value in 2011.

Stocks Can Cost Less

In these days of bargain online trades, it can cost less to buy a portfolio of stocks than it can to buy many mutual funds. That's especially true if you're planning to buy two dozen or so large, steady companies and hold them for the next 20 years. You will pay the up-front trading costs and not spend another dime until you sell. Why pay a fund 1% per year (or more) in expenses to do the same thing?

In all fairness, plenty of large-company funds charge less than 1% per year. For example,Vanguard 500 IndexVFINXcosts just 0.18% annually. That's a measly $180 on a $100,000 investment. But if you had invested that extra money in large caps instead of giving it to the fund to buy and hold large-cap stocks for you, over 10 years, compounding at a 10% rate per year, you could have earned more than $4,000, depending on how much you paid to buy your dozen stocks in the first place.

If you have the resources, consider assembling a collection of two dozen or so stable, leading companies that represent a variety of industries to form the core part of your portfolio, with a plan to hold on to these names for years to come. You'll likely save on fund-management fees and, if you've put together a diversified portfolio of the largest U.S. companies, get marketlike results.

You can then invest the remainder of your assets in mutual funds that invest in smaller companies, foreign stocks, and other styles that aren't represented within your core stock holdings.

Stocks Allow You to Control Uncle Sam's Take

This is perhaps the best reason for fund investors working within taxable accounts to consider stocks: to control their tax destinies.

Because mutual funds are required to distribute capital gains that their managers incur during the course of the year, fund investors often receive taxable distributions that they didn't want--or weren't prepared for. (For more about funds and taxes, reviewMutual Funds 104.)

But when you invest directly in stocks, you control when you buy and sell your holdings. As a result, you have more power over your tax tab. You can sell your losing stocks--and you'll more than likely have losers to sell--to offset distributed gains from your mutual funds.

Quiz 309
There is only one correct answer to each question.

1 Which is not a benefit of investing in stocks?
a. Stocks are less volatile than funds.
b. Stocks allow you to decide when you pay capital-gains taxes.
c. Stocks can cost less than funds.
2 If you want to add a little oomph to your mutual fund portfolio:
a. Sell all your funds and invest in stocks.
b. Add a few stocks at the edges of your portfolio.
c. Buy Crocs
3 Which statement is true?
a. Investing in funds is always less expensive than investing in stocks
b. Investing in stocks is always less expensive than investing in funds
c. Investing in stocks can be less expensive than investing in funds
4 If you have the resources and want to save on mutual fund expenses:
a. Pick up a few small companies and hold them for the long term
b. Buy three or four large-company stocks from the hottest sector, then when that part of the market cools, buy three or four large-company stocks from the next hottest sector, and so on
c. Assemble a collection of two dozen stable, leading companies that represent a variety of industries and hold them for years to come
5 If you want to control how much you pay in capital-gains taxes each year, which of the options below is your best choice?
a. Own mutual funds
b. Own stocks directly
c. Own both
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