Stocks vs Mutual Funds
- May 28, 2022
- by Angela
Stocks and mutual funds are popular ways of investing in the pursuit of gaining wealth. Which investment is riskier? Which investment is safer? What is meant by mutual funds? These and other questions will be answered below.
Stocks vs. Mutual Funds
Stocks are securities that represent a share in the ownership of a company. You would use your brokerage account to purchase shares at the current market price. Shares can be priced anywhere from pennies to thousands of dollars. The price the shares are trading at does not reflect the worth of the company. If you multiply the number of outstanding shares by the share price, you get the “market cap” which is the relative size (and value) of the company. The goal with stocks is to eventually sell your shares for a higher price than you paid. Stock prices rise for a number of reasons. The most common is the company’s business does well (or the market anticipates that). Another reason might be market forces (like the economy doing good), an investing bubble, or a competitor running into problems. That is the old “Buy low, sell high” wall street mantra. In practice this is a lot harder than it sounds. Stocks come with high risk and high potential reward.
A mutual fund is a collection of many stocks (or bonds) pooled together. When you buy into a mutual fund, you are buying a small slice of the combined holdings. Some funds are actively managed, which means the fund manager is making specific bets on what they think will perform better. There are also index funds, which are setup to track a particular index (such as the S&P 500) or even broader such as total market funds or world funds. The nice thing about mutual funds is you are spreading your risk across all the securities the fund holds. The holdings are managed for you. The fund handles buying and selling its holdings according to the prospectus. You do pay a small invisible fee called the expense ratio which goes towards the fund manager, overhead costs, and even advertising.
The Pros and Cons of Buying Individual Stocks:
- Easy to trade - just open a brokerage account and place your limit order when the market is open
- Opportunity for big winnings - depending on how many shares you have, you have a greater chance of gaining wealth.
- Low trading costs - In most cases, stocks have low trading costs, possibly zero. This means that some brokerage houses don't charge trading fees for individual shares.
- Total control - you can design your portfolio exactly the way you want based on your own research.
- The possibility of large losses - if the stock price drops, so does your account balance. The floor for a stock price is zero, if the company goes completely bankrupt.
- It takes time to choose stocks - researching the most suitable for your portfolio can become an obsession.
- Stress - owning individual stocks can lead to sleepless nights when things are not going well. It is easy to dwell on the price of stocks, especially when they are falling.
- Lack of diversification - they say diversification (owning lots of different things) is the only free lunch on wall street. When you own a single stock, you’ve tied that part of your fortune to whatever happens with that company for better or worse.
The Pros and Cons of Mutual Funds:
Mutual Fund Pros
- Free diversification - owning thousands of stocks in one purchase spreads out your risk. If one company in the fund runs into trouble you may not even notice it (or care).
- Long term philosophy - when you buy a mutual fund you are putting aside money for retirement vs gambling it on the hopes of a short term gain.
- Less stress - with an index fund you are basically guaranteed to match the market return, which is a nice feeling. When the market crashes you can say to yourself “hey, not just me, but everybody is going through this”.
- Dividends automatically reinvested - with stocks when you get a dividend it comes into your account as cash. With mutual funds dividends are automatically used to buy more shares, which makes compound returns automatic.
Mutual Fund Cons
- Less selection - your brokerage will want you to buy into their mutual funds and the menu of options may be pretty limited.
- Some funds have transaction fees or “loads” - watch out for funds that make you pay a fee when you buy or sell shares. In general most brokerages are doing away with this concept, but beware.
- Expenses - some funds charge a high expense ratio, which is bad for you. If possible shop around between funds that do the same thing and pick the one that has the lower expense ratio.
- Taxes - it may happen that the fund isn't tax-efficient… If the mutual fund sold its assets due to turn over or other reasons you may be subject to capital gains tax even though you haven't sold your shares in a mutual fund. This can really eat into your returns.
- No guarantee of good performance - some actively managed funds are bound to have bad luck and underperform the market.
As you can see stocks and mutual funds are pretty different animals. Mutual funds are better for investors that have a long term investment horizon and want to minimize the amount of work they put into managing their portfolio. Individual stocks are more akin to short term gambling in most situations. Individual stocks can also have a place in a portfolio given a person puts in their due diligence, they can stomach the risk, and they are using money they can afford to lose.
For more reading:
- The Eighth Wonder of the World - Compounding
- The Golden Rule: Keep Your Investment Costs Low
- What is an Expense Ratio? Part 1
- What is an Expense Ratio? Part 2
- What is Passive Index Investing?
- Don't Plan Your Retirement Saving, Automate It
- Twelve Reasons I Sleep Well at Night While Investing
- What Is Asset Allocation?
- What Is Dividend Investing?
- 16 Basic Financial Terms for Managing Money