Other than the commission on purchase and sale, there is no cost in holding individual stocks. Gain on the sale of stocks held for more than one year are eligible for long-term capital gains tax treatment. In contrast to stocks, mutual funds charge an “internal” annual fee, and you have no control over whether the mutual fund manager sells issues during the year, exposing you to short or long term capital gains. Despite these apparent shortcomings, the diversification and ongoing management available in mutual funds makes them extremely attractive.

To properly diversify a stock portfolio, you would have to identify and research hundreds of companies and invest over $200,000. For example, to purchase 100 shares (extra costs and commissions are incurred if an “odd lot” of fewer than 100 shares is purchased) of stock in 40 different companies with an average share price of $55 you would have to invest $220,000, plus commissions. Once purchased, you would have to monitor each stock and make adjustments as necessary to account for changes in the market.

Apart from diversification, mutual funds offer ongoing affordable professional management. It is the fund manager’s job to monitor the fund on a daily, if not hourly, basis. Fund managers are immune to the emotional attachments that individual investors often form with individual stocks. For these reasons, mutual funds (or managed accounts discussed below) should form the basis of your investment portfolio, with individual stocks purchased only if you have substantial investment in the stock market.

Managed accounts are similar to mutual funds in that they use a professional investment manager who follows a particular investment strategy. The difference is that the securities in a managed account belong only to you, as opposed to a mutual fund that commingles all investor’s money in a single fund with each investor owning a share.

Because the investment manager works only on your account, managed accounts typically require a minimum investment of at least $100,000. The annual fee for managed accounts is usually between two and three percent of money under management. The fee covers all commissions and internal fees.

LOAD VERSUS NO LOAD

All mutual funds charge their costs of operation to the fund. Management fees are measured as a percentage of the value of the fund, and are known as the fund’s “expense ratio” and “trading costs.” Such expenses are said to be “internal” since they are not charged directly to the investor. The expense ratio and trading costs are typically between 2% and 3% of annual assets under management. You won’t see the expense ratio on your statement. Instead, it will offset your annual return.

LOAD FUNDS

Some funds have a front-end commission, or “load,” that is charged directly to investors. Such load funds can charge commissions up-front (called “Class A” shares), or at the time of sale (“Class B” shares). The “back-end load” on Class B shares is assessed against your account if you sell the investment within the “contingent deferred commission” period. For example if you invested $10,000 in Class B shares with a four year, 4% contingent deferred charge and liquidate the account after one year you would pay a $400 commission (4% times $10,000). There would be no sales charge at all for money left in the account for five years.

NO LOAD FUNDS

No-load funds do not pay commissions. In theory, all of your dollars are working for you rather than being eaten up in commission. In reality, no-load funds must be evaluated based on their historic rate of return and their internal expenses. Some no-loads are a bargain while others lag in the only category that matters: net investment return. Unfortunately, with no brokerage fees to be earned, you’re typically on your own when it comes to evaluating no-loads.