When starting your investment journey, you may be comparing the differences between mutual funds and individual stocks, and while it’s very possible to make money investing in both, investing in mutual funds is a safer bet for your investments.
Mutual funds let you pool your money with other investors to get instant diversification, which protects your investments and by investing in these funds, you leave the management of the fund to professionals to build wealth. Diversification spreads your money out among hundreds of companies, instead of just a select few. With individual stocks, your money isn’t as protected because it lies just within that one, or a few, companies. Essentially, all your eggs are in that basket, and as a stock investor, you need to be constantly doing your research to build a portfolio that can make you money. Experts agree that mutual funds are a great wealth building vehicle.
15% of current investors started in 2020, according to a Schwab survey — which translates to millions recently beginning their financial journey. When starting your journey, weigh the upsides and downsides, and understand where your money is going. “It’s important to understand what you’re trying to accomplish,” says Monica Jalife, principal at Withum Wealth Management.
Let’s talk about the differences and why you should put your money in mutual funds instead of stocks.
What’s the Difference Between Stocks and Mutual Funds?
“A stock represents fractional ownership in an operation,” explains Dan Raju, CEO at Tradier, a fintech platform that delivers stock and options trading. “A mutual fund pulls in money from many investors to invest in some combination of many stocks and bonds.”
When you invest in just stocks, you can definitely make money but it’s just harder. You need to try and replicate the same returns that you would get with a mutual fund, but you need much more capital to do it. Mutual funds offer investors the option to invest in a diverse selection of companies. Experts agree that once you build a solid, well-diversified portfolio using investment vehicles like mutual funds, you can set some money aside to invest in stocks, but no more than 5% of your investment portfolio should go to them. Just remember that when the company loses money, so do you because the value of your stock goes down. That’s why protecting yourself with diversification is a really important part of investing.
When you invest in mutual funds, you have fund managers that make decisions within the fund, like when to buy and sell, Jalife adds. Because there are so many investors pooling their money, the fund is able to purchase at a larger scale than an individual investor can. Mutual funds protect your money in a market downturn and instantly safeguard your investments.
Here are the most common differences between mutual funds and stocks:
|Diversification||Extremely limited.||Provides instant diversification.|
|Cost||No ongoing fees after purchase.||Charges an expense ratio for the life of the investment.|
|Risk||Highest because performance depends on individual companies.||Provides protection through diversity.|
|Liquidity||Very easy to buy and sell throughout trading days.||Can only buy or sell at market close each trading day.|
|Research Required||Intensive research. Requires understanding each company’s performance.||Minimal, other than choosing the right mutual fund for your goals and checking in on your investments.|
|Portfolio Customization||Highest. You can choose the stocks you like best.||Minimal, aside from choosing the fund. You have no say in what’s included in the fund.|
Pros and Cons of Mutual Funds
The biggest pro of investing in mutual funds is that you get immediate diversification which shields you from risk in the event of a market crash. Even if the overall market declines, it’s unlikely that every company within a mutual fund will go down at once so your money is protected.
And even though mutual funds charge an annual expense ratio, or fee, it’s usually a very small percentage of your overall investments. These fees go toward managing the fund.
“If you are not very familiar or don’t have the time or desire to think about which stocks you’re going to buy, a mutual fund might be a better route,” Jalife says.
A low-cost mutual fund that tracks a broad index is a reliable investment for most investors. Be sure to understand what’s in the fund before you invest and avoid high fees.
One thing to take note of is if the mutual fund is actively managed, there could be high fees associated with that fund. For this reason, experts recommend a fund that passively tracks an index which seeks to match the performance of the overall market, and typically has low fees.
Pros and Cons of Individual Stocks
The biggest selling point and pro of buying individual stocks is the potential for outsized gains beyond average market performance. It’s also the biggest con because there’s also potential for huge losses if the company performs poorly.
For this reason, you’ll want to spend time researching the company’s financial history and future projections to make an educated decision about buying shares of stock. Even if you do, having too much of your portfolio leveraged in a handful of companies doesn’t provide much diversification, particularly if the companies are in the same sector, such as energy, materials, or real estate.
You’re responsible for creating your own diversification, Jalife advises.
Are Mutual Funds Better Than Individual Stocks?
If you have the time and want to be involved, individual stocks can potentially give you more control with lower overall costs, but here’s the risk. You need to understand the general principles of diversification and the risk your money faces when you invest in stocks. If you don’t have the time or interest, a mutual fund is a better approach to have diversity with a team of professionals managing it.
Raju adds that even though there are thousands of individual stocks on the market, there are also many options available for mutual funds. So while some research is required to find the right mutual fund for your investment goals and timeline, it’s usually more set-and-forget as opposed to selecting individual stocks, which requires ongoing research.
Mutual Funds vs. ETFs vs. Stocks
Mutual funds and ETFs are like cousins with a lot in common. “Mutual funds only have end-of-day pricing,” Raju explains, whereas an ETF is a security that you can buy or sell in real time.
You can also buy and sell stocks in real time throughout the day, but a stock represents fractional ownership in a single company, whereas a mutual fund or ETF gives you fractional ownership to hundreds or even thousands of companies with one transaction.
You can think of single stocks as the building blocks and mutual funds or ETFs as a big pool filled with those blocks. ETFs are a nice bridge between mutual funds and stocks because they have the diversity of a mutual fund with the liquidity of a stock.
Stocks don’t have any ongoing fees. You’ll only pay fees or taxes when you buy, sell, or receive dividends. Mutual funds and ETFs have ongoing fees in the form of expense ratios that pay for the fund’s management. Stocks don’t have this fee because you manage them yourself.