Should You Invest in Mutual Funds or Stocks?
Both mutual funds and stocks have their benefits. Determining which fits best with your investment style largely depends on three factors; risk-reward, timeframe, and expenses. First, you must decide how much risk you can tolerate versus how much return you want. If you want a higher return, then you must accept a higher risk.
It also depends on how much time you have (and are willing to spend) to research your investments. The amount of time you reasonably expect to spend researching financial statements or fund prospectuses will impact which of the two investment vehicles is right.
The third factor is what type of fees and expenses you are willing to endure. This point also includes differences in tax implications. Keep these three factors in mind as you learn more about the differences between these two popular investment vehicles.
The Difference Between Stocks and Mutual Funds
To better understand the differences between stocks and mutual funds, it helps to break down what exactly each product is.
When you buy a stock, you own a share of the corporation. As a partial owner, you make money in two ways. The first income you're likely to notice is a dividend payment. Stocks that offer dividends will pay out part of their profits to shareholders on a quarterly or annual basis. That provides a steady stream of taxable income throughout the time that you own the stock.
The second way to make money from stocks is to sell them. Your profit is the difference between the selling price and your purchase price (minus any fees such as commissions). Profiting from the sale of a stock is a form of "capital gain." Stocks trade continuously, and the prices change throughout the day. If the market crashes, you can get out anytime during the trading session.
Essentially mutual funds are when investors pool together their money to buy a lot of stocks (mutual funds can also include bonds or other securities, depending on the fund). You own a mutual fund share, which entitles you to a proportional share in the underlying basket of securities. The proportional ownership is reflected in the price of each mutual fund share, known as the net asset value (NAV). NAV is the total value of all the securities the mutual fund owns divided by the number of shares.
An investor can place an order for mutual fund shares at any point during the trading day, but the order won't execute until the next NAV adjustment—usually at the end of each business day. That makes it difficult to control your buying price, especially when the overall market experiences extreme volatility.
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 and index or benchmark, such as the S&P 500, and replicate it with the fund's holdings.
Exchange-traded funds (ETFs) have similarities to mutual funds, as well as differences. One similarity is that ETFs can be either actively or passively managed. Actively managed ETFs usually charge higher fees than passively managed index ETFs.
Mutual funds come in many different flavors and categories. Inside the first few pages of a mutual fund's prospectus will be—by law—an investment objective policy statement saying what that fund's managers specifically hope to achieve, as well as a description of the securities each fund is or is not allowed to actually invest in. This assortment allows you to focus on a particular type of company, such as small or large companies, as well as specific industries or geographic regions.
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.
As with stocks, mutual funds earn money for investors through dividends and capital gains. Unlike stocks, individual mutual fund investors don't control what kind of dividends to seek out or when to sell stocks. That's all up to the mutual fund manager. It's common for mutual funds to distribute dividends and capital gains (as well as capital gains taxes) annually or quarterly.
Balancing Risk With Reward
Stocks are riskier than mutual funds, and this fact primarily comes down to something known as "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.
Mutual funds achieve diversification in two ways. First, depending on the type of mutual fund you're considering, it may contain a mix of stocks and bonds. Bonds are a relatively safer investment than stocks, so mixing them into your portfolio helps reduce risk.
Secondly, 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.
For example, consider Lehman Brothers. In 2008, when Lehman Brothers filed for bankruptcy, it was the fourth-largest investment bank in the U.S. As such, a major company, 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.
The tradeoff is that most mutual funds won’t increase as much as the best stock performers. For example, in Amazon's initial filings with the Securities and Exchange Commission in 1997, it estimated that shares would begin selling for between $14 and $16. On April 8, 2020, Amazon shares opened at more than $2,021. Individual investors who bought stock in the late '90s could potentially enjoy all of the equity gains that came with that meteoric rise. The benefits of that kind of rapid growth are muted for mutual fund holders.
By considering both your emotional tolerance for risk, as well as your financial situation, you can determine a risk/reward ratio that works best for you.
The second factor is how much time you want to spend on research, and whether you have the patience to learn how to evaluate financial statements. To put it simply, if you want to save time, go with a mutual fund.
The people who are better suited for stock investing need to 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 also 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.
Investors still need to research mutual funds, but there's a lot less work to do. You just need to figure out 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.
Once you've done that, the bulk of your research is finished. 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.
Mutual fund investors should continue to pay attention to the fund by reading the prospectus that updates investors on the fund's goals and holdings. It's also a good idea to keep track of the overall economy.
Costs and Fees
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.
Mutual funds come with fees. It's difficult to broadly examine mutual fund fees because they vary from one fund to the next. Some funds charge fees when you buy the fund, while others charge fees when you sell the fund, and still, others 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.
You can minimize the impact of taxes using tax-advantaged retirement accounts, such as a Roth IRA or 401(k). There are also tax advantages to choosing ETFs over mutual funds.
The Bottom Line
While everyone's situation is different, there are some generalities you can use to guide your investment decisions. If you want to minimize your risk and research time, and you're willing to take on some extra costs and fees for that convenience, then mutual funds may be a better investment choice. 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.