PeopleImages / Getty Images Determining which fits best with your investment style largely depends on four factors: risk, reward, timeframe, and expenses.
What’s the Difference Between Mutual Funds and Stocks?
Even when a mutual fund holds 100% stocks, those stocks aren’t all in one company. If a single company gets hit with a scandal that causes the stock to tank, a mutual fund investor won’t be hit as hard as an investor that only owns that company’s stock. Mutual funds are less risky than individual stocks due to the funds’ diversification. Diversifying your assets is a key tactic for investors who want to limit their risk. However, limiting your risk may limit the returns you’ll ultimately receive from your investment. Consider Lehman Brothers. In 2008, when Lehman Brothers filed for bankruptcy, it was the fourth-largest investment bank in the U.S. Many mutual funds contained Lehman Brothers stock, and they suffered a decline when Lehman Brothers folded. However, individual investors who bought and held stock in the now-liquidated company lost all the money they invested.
Potential Rewards: Mutual Funds vs. Stocks
Mutual funds don’t even necessarily need to contain stocks. Bond funds primarily invest in bonds or other types of debt securities that return a fixed income. They are relatively safe, but they historically provide smaller returns than stock funds.
Time: Mutual Funds vs. Stocks
Mutual funds are overseen by a fund manager, who controls when and what to buy or sell with all investors’ money. Management can be either active or passive. Actively managed funds have a manager who seeks to outperform the market. Managers for passively managed funds simply pick an index or benchmark, such as the S&P 500, and replicate it with the fund’s holdings. Investors still need to research mutual funds, but there’s less work involved. You decide what type of mutual fund you need, whether it’s an index fund, a fund for a specific sector, or a target-date fund that adapts with an investor’s needs over time. You should also look at the historical performance of a mutual fund and compare it to similar funds that track the same index or benchmark. You don’t need to worry about what stocks are in the mutual fund or when to sell them. The mutual fund manager will research individual investments and decide what trades to make. When considering stocks or mutual funds, decide how much time you want to spend on research and whether you have the patience to learn how to evaluate financial statements. If you want to invest less time, go with a mutual fund. Stock investors should research each company they consider adding to their portfolio. They must learn how to read financial reports. These reports tell investors exactly how much money the company makes, where the income comes from, and how the company plans to grow earnings. This information helps investors determine how much a company is worth and whether the stock price is proportional to that value. Stock investors need to stay on top of how the overall economy is doing. A company can be making all the right decisions, but that doesn’t stop the stock from declining if bad news hits the industry, or if a broad recession causes the entire economy to slump. This work is multiplied for investors who want to maintain a diversified, well-balanced portfolio. You’ll need to pick companies from various industries with different sizes and strategies. Each potential investment requires research. You might need to investigate dozens of companies to find a few good ones.
Costs and Fees: Mutual Funds vs. Stocks
Mutual funds come with fees that vary from one fund to the next. Some funds charge fees when you buy the fund, others charge fees when you sell the fund, and some don’t charge at all if you hold for a certain length of time. Many funds charge management fees to compensate fund managers. Some funds require a minimum investment, which can raise the cost-related barriers to entry. Most actively managed funds buy and sell stocks throughout the year. If they incur capital gains on those trades, you may have to pay taxes on it, even if you didn’t personally sell any mutual fund shares. Even if the overall value of the mutual fund declines, you could incur capital gains taxes for sales made by the fund. If you’re primarily concerned with avoiding extra costs and fees, stock investing is the way to go. You’ll still pay taxes on dividends and capital gains, but other than that, the only fees you’ll incur are those that your brokerage applies to trade orders. If you have a commission-free brokerage, you won’t pay these fees. On the other hand, if you enjoy diving deep into financial research, taking on risk, and avoiding fees, then stock investing may be the better option. You must decide how much risk you can tolerate versus how much money you want to make. If you want a higher return, you must accept a higher risk.
