Last Updated: May 28, 2021
People who want to invest in the stock market might be faced with the choice of mutual funds vs stocks. So let’s get to know each of them in-depth, see what are their pros and cons, and analyze their risks and rewards. We know that creating an investment strategy can be overwhelming, and we’re here to help.
What Is the Difference Between Mutual Funds and Stocks?
While it’s generally good practice to keep most of your portfolio in stocks, this doesn’t mean that it has to be individual stocks. Mutual funds have become increasingly popular recently. This is partially because they allow small investors access to professionally managed portfolios.
Understanding each product in detail is crucial to understanding what the differences between them are and whether owning stocks or mutual funds is worth it.
What are stocks?
Stocks represent the ownership of a fraction of a corporation. When you buy stocks, you’re buying ownership of the corporation’s assets and profits and, in some cases, the right to vote. There are two main types:
Preferred stock is a specific class of stock that gives different rights compared to common stock. They give shareholders a higher claim to assets and earnings in the event that the corporation goes bankrupt and higher dividend payments. However, owners don’t have the right to vote or have very limited voting rights. They are harder to find than common stock.
As the name suggests, common stocks are more common. They’re easier to find and, unlike preferred stocks, they give owners full voting rights while still giving them a claim to assets and earnings.
Anyone asking themselves “should I buy individual stocks?” needs to know how they can make money from them.
You can do that in two ways:
- The first one is to buy stocks and hold them until their price rises sometime in the future so you can sell at a profit.
- The second one is to earn dividends provided by some stocks.
A disadvantage of single stocks is the fact that there are no guarantees that the stocks will rise. The amount you should invest is the amount you can stand to lose. While day trading is an option, stocks are considered a more long-term investment. According to financial experts, you shouldn’t invest in stocks money you will need in the next five years.
What is a mutual fund and how is it different from stock?
A mutual fund is an open-end investment fund managed by professional managers. They pool money from many investors that they use to purchase securities and attempt to produce capital gains or income for their investors. A mutual funds portfolio can contain stocks, stock options, bonds, equities, and other securities.
Mutual funds are both companies and investments. This might seem confusing at first, but it’s really simple. For example, when you buy shares of TSLA, you buy partial ownership of Tesla. Similarly, when you invest in a mutual fund, you buy partial ownership of that mutual fund and its assets. The difference is that Tesla is in the business of electric vehicles and clean energy, but a mutual fund company is in the business of investing.
To sum up the difference between single stocks and mutual funds: single stocks are an investment in a single company, while mutual funds can have many investments, including stocks, under a single fund.
The price of a mutual fund is called the net asset value per share or NAV/NAVPS for short. This figure is derived from dividing the total value of all securities in the portfolio by the total amount of outstanding shares. The NAV does not fluctuate during market hours — it’s settled at the end of each trading day.
On average, a mutual fund has invested in over a hundred securities. This means that shareholders gain significant diversification at a cost-effective rate. Losses are present when investing in both stocks and mutual funds, but diversification significantly decreases the losses for the investor.
Let’s consider this scenario: Jim has invested only in Apple shares right before they have a bad quarter. On the other hand, Michelle has invested in a mutual fund that happens to own some Apple stocks. When the bad quarter comes around, Jim stands to lose a lot more of his investment than Michelle due to the diversification that mutual funds offer.
Similarly to single stock investing, there are three ways you can make money from mutual funds:
- Earned dividends from the stocks or interests on bonds held by the fund.
- If the fund’s shares increase in price, you can sell them at a profit.
- The fund has a capital gain from selling securities that have increased in price.
At the end of the year, the fund will pay out nearly all the income it receives. Since it is a virtual company, the fund manager is hired by a board of directors and is legally obligated to work in the best interest of investors. Most of the time, managers are owners or investors in that fund themselves. There are very few employees, but the staff includes compliance officers, an attorney, and an accountant to calculate the NAV.
Types of mutual funds
When it comes to types of stocks vs types of mutual funds, there are far more types of mutual funds:
- Equity funds – This is the biggest category. They invest primarily in stocks.
- Fixed-income funds – This type of fund focuses on paying a set rate of return. The idea behind this is that the assets of the portfolio are set so that they generate income.
- Index funds – Index funds have become extremely popular. The idea is that, since it’s very hard to beat the market, they buy stocks that correspond with major market indexes such as S&P 500 or DJIA.
- Balanced funds – They contain a mix of investments like bonds, stocks, and other alternatives. Also known as asset allocation funds, their objective is to minimize exposure across asset classes.
- Money market funds – Considered to be risk-free because they place their money in short-term debt instruments like government treasury bills. Investing in these funds won’t make you large profits like choosing to invest in stocks or other types of mutual funds would, but you also won’t risk losing your principal.
- Income funds – The primary goal of this fund is a steady cash flow, and because of this, most investors are retirees and conservative investors. The fund invests in bonds and holds them so they can provide a steady stream.
- International/global funds – International funds invest in assets outside the home country while a global fund invests worldwide, including the home country.
- Exchange-traded funds (ETFs) – This is a hybrid between mutual funds and stocks. They offer all the advantages of mutual funds and the option to be traded daily like stocks.
One disadvantage of mutual funds is their fees. Mutual Funds have two kinds of fees and expenses: shareholder fees and operation fees.
- Annual operation fees are administrative costs and management fees.
- Shareholder fees come from commissions and sales charges. Mutual funds are front-loaded, and the ’load’ refers to the sales charges that are assessed when an investor purchases his shares. The backload is calculated when shares are sold. Sometimes a fund doesn’t charge any commissions or sales fees. Other times they charge early withdrawal fees.
ETF vs Stock vs Mutual Fund
While an ETF is a type of mutual fund, there’s one big difference: it can be traded during the day. So it combines all the advantages that mutual funds offer, like lower risk and built-in diversification, with the liquidity of individual stocks.
Additionally, ETFs are passively managed, and they often have lower expenses than actively managed mutual funds or stocks. They also have lower minimum investment requirements than mutual funds. So when you combine all benefits like cost-efficiency, accessibility, lower risk, and liquidity, it’s easy to see why they have risen in popularity in the past 10 years.
When it comes to comparing ETFs vs stocks, there is a catch you should know about. While people trading stocks usually try to beat the market, ETFs are designed to follow the market, not beat it.
Investing in individual stocks is the best tool to actually beat the market. However, it requires a lot of investment skill, significant research, a bit of luck, and maybe even help from an expert. Depending on the specific stock, it can be more affordable than mutual funds, but it’s always riskier and more time-consuming.
Mutual Funds vs Stocks: Side by Side Comparison
Stocks, options, and mutual funds complement each other well in a portfolio. Choosing one over the others is really up to you as an investor and depends on your investment goals.
Having said that, knowing the key differences is crucial to making your decision. And after that, you can always consult a professional or try a robo-advisor.
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Should I Invest in Mutual Funds or Stocks?
Let’s put them side by side and see which one offers more rewards and which one is less risky.
The biggest, most obvious difference when debating mutual funds vs stocks is that mutual funds offer easy diversification. Once you invest in a fund, that investment is already diversified between the different assets. This can significantly reduce the risk of investment.
To tie in with the point above: There is no rule that says that you can’t diversify the stock you are investing in by yourself. However, that does require that you spend a lot of time researching each stock that you intend to purchase and consulting experts. All in all, just investing in mutual funds is easier and will save you time.
Another difference between mutual funds and stocks is the fact that mutual funds are always professionally managed. This gives them somewhat of an advantage over single stocks. This also means that every decision made to beat or follow the market is made by a professional with experience. However, many investors debate if professionals are any better at picking your stocks than you are. Professional management is not infallible and can have higher fees.
This is where you ask yourself what your investment goals are. Generally, stocks are considered riskier because you can’t tell if their price will rise or plummet, but a single stocks’ return can potentially be much higher. By contrast, funds are designed to follow the market and not beat it.
While professional management is convenient, it does come at a cost. It can reduce your overall payout. If there are years where the fund doesn’t make money, the fees are just losses that you are not investing, and the manager still has to be paid. On top of that, a lot of funds have a $1,000 minimum investment or more.
On the other hand, if you choose an ETF or stocks, you still have to pay commission when you buy or sell. Stocks tend to be tax-efficient if you control capital gains by timing when to buy or sell.
Stocks are highly liquid. What this means is that you can turn your investment into cash whenever you want. Mutual funds are fairly liquid, and in most cases, you can liquidate them when the trading day is over. Be careful though, as different funds have different rules, and you may incur fees for selling early.
A healthy portfolio should be balanced. Meaning you should invest in different options to maximize gain and reduce risk. The answer to the mutual funds vs stocks debate should really be based on your personal preference, your investment goals, and risk tolerance.
Mutual funds that have a track record of achieving higher returns than the markets they are operating in (after deducting their associated costs) can be a good investment. The disadvantage of mutual funds is their cost and their active management — if one isn’t beating (or is on par with) the market performance, then an index fund is a better option, with lower costs.
Generally, mutual funds are considered less risky than single stocks because they offer diversification of assets. While this may be true, they do carry their own risks, like mismanagement of the fund. There are also years in which the fund doesn’t make money, and in those years, you are only paying fees.
Yes, mutual funds tend to be safer than stocks. Their “safety” stems from their built-in diversity. There’s a very low chance that a single stock’s return is going to beat the overall market trend in a year. The breadth, or range, of stocks owned lowers the risk of investing in funds compared to a single asset within a given class.
The way you profit is similar whether you own stocks or mutual funds. There are two main ways you can profit from a mutual fund. One way is if the fund earns dividends on stocks or interest on bonds, this will be distributed among investors. Also, if the fund has sold securities and has capital gains, they will be distributed among investors. The second way to profit from a fund is by selling fund shares if they increase in price.
No mutual fund management team consistently beats the market, and most don’t even come close. Forbes reported on it in 2020 by presenting statistics sourced from multiple reports that show that only 2% of fund managers outperform the market by an amount greater than their fees, and an additional 16% perform in-line with their fees.
Mutual funds are good for short to mid-term investing, given a track record of outperforming the market. However, the higher fees (when comparing mutual funds vs stocks), possible errors in fund management, or bad investment decisions, can significantly impair long-term growth. Index funds and ETFs with low fees mitigate these risks and are better long-term options.