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Why Picking Stocks Is Better Than Picking Funds

Investors with enough time to do the research are better off picking out high-quality stocks than buying index or mutual funds, Cramer said.

Sure, index funds are fine if you want an average return, but there’s something inherently wrong with them. At any given time, they’re weighed down by bad stocks – stocks that anyone with a brain could spot. If you ask Cramer, buying an index fund is like saying you’re brain couldn’t do any better.

Mutual funds have their own problems. The money they make doesn’t come from performance incentives so much as fees. So they only need to do well enough to attract more of those fees, Cramer said. Since their job is to attract new investors and make the fund bigger so it can collect more fees, a good mutual fund will ultimately get very big. Then it ends up looking like an index fund, which will most likely reflect the performance of the market on the whole.

And that’s not to say Cramer doesn’t recommend mutual funds. If you only have a couple of hours a week for homework, then find a good diversified fund with a long record of performance. You only need one, Cramer said. Mutual funds are diverse by definition, so there’s no reason to own two or three or five.

Exchange-traded funds are usually highly specialized and sector-weighted. There’s an oil-services ETF, a biotech ETF, etc. But it takes just as much homework to strategize sectors as it does individual stocks, and an ETF is just like any fund – it’s going to have bad stocks you don’t want to own. Why not just pick out the individual good stocks in a sector?

If you’re an individual investor, then you’re small and limber. You also only own the best picks you could find; the ones you think will bring in the biggest returns. This should put you ahead of mutual funds because they’re only looking for decent returns. So Cramer recommends you find at least five, but no more than 10, well-researched stocks for your portfolio. The five will keep you diversified. Ten or less will keep things manageable.

And don’t get fancy with shorts or options. These are professional-level strategies for traders with lots of time of their hands – like the 80+ hours a week Cramer worked at his hedge fund. Risk might bring more reward, but it brings even more work. If you’re only devoting 10 hours a week to your stocks, then you’re not spending enough time watching your money to handle the extra risk, Cramer said.

Bottom Line: If you don’t have the time or that much money to invest, mutual funds are for you. But if you have the time, and you have a brain, then you should be able to outperform the indexes, the mutual funds that look so much like them, and any group of sector weighted ETFs, because all these things are loaded down with bad stocks, and you don’t have to be.

Questions for Cramer? madmoney@cnbc.com

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  • Jim Cramer is host of CNBC's "Mad Money" and co-anchor of the 9 a.m. ET hour of CNBC's "Squawk on the Street."

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