James wrote:
“If I hold those stocks for 20 years without ever rebalancing, that’s $150/year.”
Well, it is $3000 for the first year, and then $0 for the remaining 19 years. If you were to invest the $3000 at 5% per year, then you would receive $150/year before taxes. This $150 would wash with the 0.2% annual management fees for a typical SP500 index mutual fund with exactly $75,000.
The question is whether you want to have $3000 in the bank or give it to a stock brokerage firm in the form of commissions.
I have difficulty paying $3,000 to make a $75,000 investment (works out to a 4% commission). Now if I were making a 1 million dollar investment then $3,000 fee is much more reasonable!
In order to calculate the break-even point (which is what you are trying to do), you need more information. In particular, you need to factor in the expected annual return on the index.
As the index increases (or decreases), your annual management fees increase (or decrease). So your expenses each year would vary, ($150 for YR1, $175 for YR2, $200 for YR3, $195 for YR4, $225 for YR5, …, $500 for YR18, $450 for YR19, $425 for YR20) .
If you look at the problem this way, then paying the $3000 upfront is worth it, assuming an index growth rate greater than the risk free rate.
However, you would NEVER buy the all companies in the SP500 with only a $75,000 starting investment.
Here is why. The SP500 is a market capitalization based index. The first 10 stocks (ranked by market cap descending order) would comprise approximately 25% of your portfolio’s value. So you would have $56,250 left to purchase the remaining 490 stocks. As you get towards the bottom of the SP500, you might be purchasing $10 - $20 of each company at $6 per transaction (assuming the stock price is in this range, otherwise you could purchase exactly 1 share). Ouch! (30% - 60% transaction fee)
Then comes the nightmare of taxes, dividends, mergers, company bankruptcies, reading annual reports,…, for all 500 of these companies each year for 20 years! And of course, your portfolio will look nothing like the SP500 at this future date.
James wrote:
“If I buy 10 stocks and hold them for 20 years, I might pay less in commissions and management fees, but I’m much less diversified, right?”
With a 10 stock portfolio you are less diversified than with a 500 stock portfolio. However, you can build a diversified portfolio with 25 – 40 stocks. As the number of stocks in a portfolio increases, risk decreases. But the curve starts to flatten out around 25 stocks. Note: this assumes the stocks in your portfolio are not all in the same industry or complement each other. A portfolio of 40 technology stocks may not have significantly less risk than a portfolio of 10 technology stocks.
James wrote:
‘There is definitely a point at which mutual funds become less cost-effective than buying individual stocks.”
Totally agree with you. As you mentioned, you will probably need a cool million $ to invest to reap the benefits of individual stock investing.
Here is a fun solution. Put 90% of your money into index funds (mutual or ETF) and the remaining 10% in individual stocks (a few of them, not 500!).
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