When investing in the stock market, you have a choice: you can purchase individual stocks or you can purchase mutual funds. Buying individual stocks enables you to invest in the future of a small handful of companies you like while investing in mutual funds enables you quickly build a diversified portfolio of dozens or hundreds of stocks.
Individual stocks and mutual funds each have their benefits and drawbacks. So, you may be wondering, should I invest in stocks or mutual funds? If so, you’re in the right place! In this guide, we’ll highlight the important differences and help you decide whether stocks or mutual funds are right for you.
Stocks vs. Mutual Funds
Before we dive into the pros and cons of stocks and mutual funds, it’s important to understand the differences between them.
Stocks are shares of a single company. When you buy an individual stock, you only get financial exposure to that one company rather than to the entire stock market.
Mutual funds are baskets of stocks. When you buy a mutual fund, what you’re really purchasing is fractional shares of dozens of even hundreds of different companies.
In general, stocks are best if you want to build your own custom portfolio of a few dozen companies and you’re willing to take on a little more risk. Mutual funds are best if you want to invest in an already diversified portfolio that’s managed by professionals.
Pros Of Investing In Stocks
Control Over Your Investment
The number one reason that many investors choose to purchase individual stocks rather than mutual funds is that stocks offer total control over your investment. You get to choose exactly which companies to invest in, when to sell specific companies out of your portfolio, and how great a portion of your portfolio each company makes up.
For example, if you know you want to own stock in Apple, you can purchase stock in Apple (vs. looking for a fund with exposure to Apple’s stock).
Small Minimum Investment
When investing in stocks, you only need to invest enough money to buy one share. For most stocks, that’s a few hundred dollars or less. Many brokers now offer fractional share investing, too, in which case you can invest as little as $1 in any stock no matter the share price.
Potentially Higher Returns
Individual stocks are more volatile than mutual funds, meaning that the price can jump up or down to a greater degree. That makes stocks riskier, but your potential reward is greater if you pick a winner. For example, Tesla gained 743% in 2020 compared to 16% for the S&P 500.
High Liquidity
You can buy or sell stocks nearly instantaneously at any time during market hours. That makes it easy to move from one stock investment to another or to free up cash for other purposes. Mutual funds are less liquid and usually bought or sold at the close price.
Tax Flexibility
When investing in individual stocks, you get to decide when to buy or sell. As a result, you can make decisions about whether to hold shares for a year or longer to avoid short-term capital gains taxes or to sell off losing investments to deduct from your profits at tax time.
Cons Of Investing In Stocks
Greater Risk
Individual stock investing is inherently riskier than mutual fund investing. When you buy individual stocks, your portfolio can be upended by a bad earnings report or a single underperforming company. Individual stocks tend to be more volatile than mutual funds, too, so your portfolio’s value can swing up and down over time.
Less Diversification
Unless you invest in dozens of stocks – which takes a lot of time and isn’t always practical – your portfolio will be less diversified than if you were to invest in mutual funds. That’s not necessarily a bad thing if you pick winning stocks, but it does leave you more exposed if the stock market goes encounters a rough patch.
Time Intensive
The crucial element that holds many investors back from buying individual stocks is how much time and research it takes. Finding a winning stock is difficult – professional investors spend all day, every day trying, and many end up failing. Be prepared to dive deep into financial reports, charts, and other data if you decide to invest in individual stocks.
Pros Of Investing In Mutual Funds
Convenient Diversification
A major appeal of mutual funds is how simple they make the process of building a diversified portfolio. With one trade, you can get exposure to dozens or even hundreds of different companies. You also save time by researching a single fund instead of hundreds of individual companies.
Lower Risk
Mutual funds tend to be less volatile than individual stocks, since a loss by one company in the fund may be balanced by a gain in another. So, it’s rare for mutual funds to experience precipitous declines in the same way as individual stocks sometimes do.
Professional Management
Mutual funds are monitored by professional fund managers, who buy and sell stocks within the fund to ensure the portfolio remains balanced. You can also find mutual funds that are actively managed to generate greater gains (although these typically have higher fees).
Packaged Investing Themes
While there are mutual funds that simply track the whole stock market, many funds are built around specific themes. For example, you can invest in mutual funds that track small-cap stocks, emerging markets, the tech sector, or environmentally responsible companies.
Cons Of Investing In Mutual Funds
Management Fees
Most mutual funds come with management fees that are based on the size of your investment, not your profits. These can eat significantly into your investment returns over the long run.
Investment Minimums
Many mutual funds have minimum investment thresholds, which can be in the thousands of dollars. The good news is that these thresholds are often waived if you want to add more money to a fund after your initial investment.
Modest Performance
Mutual funds often fail to outperform the overall stock market, and many underperform it by several percent. Even if a fund contains several stocks that see huge returns, those returns are weighed down by more modest performance from the rest of the portfolio.
Low Liquidity
Mutual funds only trade at the end of each day. So, if you want to add or remove money to or from a fund, you can only do so once per day.
Tax Consequences
Mutual fund managers buy and sell stocks in the fund on a regular basis, which can have tax consequences for you at the end of the year. Unfortunately, you don’t have much control over whether positions in the fund are sold for short-term or long-term gains.
Should You Invest In Stocks Or Mutual Funds?
Mutual funds offer a more hands-off approach to investing that appeals to many people. If you don’t find pleasure in stock analysis or want to invest your money and then forget about it, mutual fund investing will be preferable to individual stock investing. Mutual funds also tend to be best if you want to keep your investing risk to a minimum, although there are riskier active funds available.
Stock investing is best for investors who want to maximize their potential returns and cut their investing costs, and who don’t mind more investing risk. Finding individual stocks to invest in and building a diversified portfolio on your own is extremely time consuming. So, you’ll also need to have some enthusiasm for stock analysis.
One approach that many investors take is to invest the majority of their funds – say, 80% – in mutual funds to create a well-diversified portfolio. Then you can use the remaining 20% to invest in individual stocks. That way, you don’t have to worry quite as much about diversification or risk management, and you’re free to search for stocks that you think can beat the market.
Conclusion: Stocks Vs. Mutual Funds
Choosing between individual stock investing or mutual funds is a key part of building a portfolio and managing your investment risk. Both individual stocks and mutual funds have advantages and disadvantages, so it’s important to think carefully about which is better for you. Keep in mind that the two approaches aren’t mutually exclusive, and many investors hold both individual stocks and mutual funds in their portfolios.
