Asset mix makes mutual funds attractive

Q: I have several mutual funds in my taxable account and my self-directed 401(k) plan. Should I reinvest the capital gains and/or the distributions?

I am thinking the cash could be used to buy stocks that are getting hammered in the down market right now.

One of my co-workers recommends that I sell all of my funds and switch to individual stocks. If you agree with either or both of these, how many individual stocks should I buy?

A: If you would like to try your hand at picking a few individual stocks for your portfolio and don't have new money to add to your account, not reinvesting the capital gains and dividends and directing them to a cash account would be a good option.

But if you are invested in stock mutual funds within the appropriate asset classes for your situation, you are probably better off reinvesting your capital gains and other distributions in your mutual funds.

One of the main advantages of mutual funds is diversification.

If you are invested in a passively managed or index fund, the reinvested distributions will automatically buy more shares of the basket of stocks in which the fund is invested.

If you are invested in actively managed funds, I assume you have confidence in the fund managers to select which stocks within the portfolio to buy or sell and the number of shares.

By reinvesting your distributions in an actively managed fund, you will buy more shares of stocks that the manager selects.

Unless you have a lot of money, you may not have the ability to purchase a large number of stocks other than through a mutual or exchanged traded fund.

The greater the number of stocks you own, the less risk you have that the stock of the companies in which you are investing will fall out of favor or worse, declare bankruptcy.

The typical stock mutual fund holds stock of 25 to 100 companies. Most advisers recommend that an investor hold at least10 mutual funds that, if selected properly, will produce a portfolio consisting of more than 250 stocks. This diversification can be achieved at a relatively low cost and with a fairly small amount of money.

If you have $1,000 and want to own individual stocks in at least 10 companies, each stock purchase of $100 will have a transaction fee. If this fee is $10, your $1,000 investment will immediately be down 10 percent.

If you invest in a mutual fund, you will own stocks of many different companies, and you normally will not have transaction fees.

If you are charged a transaction fee as described above, the $10 will be charged on the total $1,000 invested in the fund, and your account will immediately be down 1 percent as opposed to 10 percent. Mutual funds may or may not have a sales charge.

The following brief description of the main classes of mutual fund shares might be helpful:

* A-share mutual funds have a front-end sales charge. The broker or adviser is paid up front as soon as you buy the fund. They may also have a trailer or 12b-1 fee, or what may be described as basis points.

* B-share mutual funds have back-end sales or surrender charges levied on investors who sell shares six to eight years after buying them. A typical surrender charge will be six percent the first year and gradually decrease to zero over the next five to seven years. The broker or adviser gets paid a certain amount up front and then receives part of the trailer or 12b-1 fee for several years after your purchase.

* C-share mutual funds have a trailer fee that is paid to the broker or adviser as long as you own the fund.

* No-load mutual funds have only one class -- there is no front-end or back-end fee or load. They may charge a small 12b-1 fee that is paid to a discount brokerage to be part of their no-transaction-fee fund selection. There are no commissions paid to brokers or advisers.