Council Post: Four Advantages Of Owning Stocks Over Mutual Funds Or ETFs

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Ty Bernicke, CFP®, is President and Executive Wealth Manager at Bernicke Wealth Management based in Eau Claire, WI.

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There are generally three different categories of investors when it comes to investing in stocks. The first category believes that paying extra for actively managed investments, like many mutual funds, can provide returns that outweigh the additional costs. The second investor category believes that you should own low-cost index funds and/or ETFs because these investments reduce unnecessary fees, which equals more money in your pocket. The final category of investors believes that owning individual stocks is the superior technique. Although each method has its advantages, the remainder of this article will focus on the benefits of owning individual stocks in nonqualified accounts. Nonqualified accounts are another term for money not invested in an IRA, Roth IRA, 401(k) or other tax-advantaged retirement plans.

The first advantage associated with owning individual stocks is tax efficiency. It is first important to understand how stocks are taxed in nonqualified accounts to understand tax efficiency. Many stocks pay dividends, and these dividends are taxed in the year they are received. If the dividends are qualified, they are taxed at a lower rate than ordinary income taxes.

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An additional form of taxation associated with stocks is called capital gains tax. Capital gains taxes are owed on a stock’s appreciation after a stock is sold. Capital gains tax can be delayed indefinitely into the future if the investor does not sell the stock. Furthermore, if an investor holds a stock for at least 12 months, the capital gains are also taxed at a favorable rate compared to ordinary income taxes. Additionally, if an owner of an appreciated stock dies, their beneficiary can receive a step-up in cost basis. The step-up in cost basis wipes out all taxation associated with previously earned gains.

The tax efficiency associated with owning individual stocks compared with mutual funds can be seen in several circumstances. If you own a group of individual stocks, there will be times when it is advantageous to sell one of the stocks that may be down in value to take a loss that can reduce taxes. There are other times when it would make sense to donate highly appreciated shares of stock to charity instead of writing out a check, which can provide tax deductions for those who itemize while also avoiding tax on the stock’s appreciation. These same strategies cannot be utilized with actively managed mutual funds, index funds or ETFs as you cannot isolate the most advantageous stocks within these funds to sell or gift.

An additional tax efficiency advantage that stocks have over mutual funds includes no inherited capital gains. Inherited capital gains occur within stock mutual funds because every current owner of the fund shares in the annual capital gains tax associated with the entire fund yearly. For example, let’s say a mutual fund had several stocks that had previously been appreciated, and you decide to buy into this mutual fund.

In the same year you purchase this mutual fund, the manager decides to sell the highly appreciated stocks. All the current mutual fund owners would have to share the capital gains tax responsibility in proportion to their ownership in the mutual fund, even those that did not benefit from the appreciated stocks’ previous gains. Essentially you can end up paying taxes on other investors’ gains from previous years. When you purchase your own individual stocks, you do not have to worry about paying taxes on previous stock gains that you did not benefit from because you always start from scratch.

A second advantage that individual stocks ownership has is cost. According to a recent study From the Investment Company Institute, the average annual cost for actively managed stock funds was 0.50%, and the average annual cost for stock index funds is 0.06%. The cost for holding individual stocks in most national discount brokerage firms is $0, and many national discount brokerages allow you to buy and sell stocks commission-free as well.

The third advantage of individual stock ownership is control. When you own mutual funds or ETFs, you must accept the basket of stocks within the fund. Depending on your interests, companies within the fund may not mesh with your personal beliefs. Unfortunately, there is little that you can do to exclude these stocks from your mutual funds or ETFs. When you own your portfolio of stocks, you have absolute control to exclude any company you want.

A final advantage of individual stock ownership is diversification. Presently several of the most popular mutual funds and ETFs globally are index funds or index ETFs. These indexed investments are diversified according to a capitalization-weighted index like the S&P 500. Capitalization-weighted indices like the S&P 500 index assign proportionally larger amounts of money to the largest companies. For example, if ABC company is 100 times larger than XYZ company, ABC would have 100 times as much money invested into it, causing overconcentration in one stock.

In addition to larger companies receiving disproportionately larger investments than other companies, this problem can morph into a much larger issue when entire stock market sectors do well relative to other sectors. We call this sector bloat. Sector bloat occurred in 2001 with technology stocks shortly before this sector crashed by over 71%. This also happened in the 2008 financial crisis when the largest sector of the S&P 500 was the financial sector. Presently, one could argue that sector bloat is happening again as the technology and communications sectors of the stock market represent over 35% of the S&P 500 index.

In summary, if you want absolute control over your portfolio allocation at a favorable price point with greater tax efficiency, you may want to consider using individual stocks for the nonqualified portion of your portfolio.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?


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