Stocks and mutual funds offer several benefits for investors. When you buy a stock, you own a share of the corporation. You can make money when stockholders receive dividend payments and when you sell the stock. That provides a steady stream of taxable income throughout the time that you own the stock. When you buy a mutual fund, you are pooling your money with other investors to buy stocks and other securities.
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?
|Risk/Diversification||More specific risk (less diversification)||Less specific risk (more diversification)|
|Time||More time consuming||Less time consuming|
|Costs and Fees||Lower fees||Higher fees|
Risk: Mutual Funds vs. Stock
Mutual funds achieve diversification in two ways. 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.
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.
By considering both your emotional tolerance for risk and your financial situation, you can determine a risk-to-reward ratio that works best for you.
Potential Rewards: Mutual Funds vs. Stocks
The tradeoff for incurring less risk by choosing a mutual fund over stocks 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 1990s 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.
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.
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.
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.
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.
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.
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. 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.
Frequently Asked Questions (FAQs)
Are mutual funds risky?
There's some amount of risk in all investments, but the exact amount of risk in a mutual fund depends heavily on what kind of fund it is. An actively managed growth fund will have much more risk than a Treasury bond mutual fund, but the Treasury bond mutual fund will be among the lowest-risk investment products available. Compared to individual stocks, a broad index mutual fund is less risky.
How do you buy stocks or mutual funds?
Both stocks and mutual funds can be bought with most kinds of investment accounts, including brokerage accounts and retirement accounts. However, buy orders for stocks are different from those of mutual funds. Stock orders can execute as soon as shares are available at a price you're willing to pay. If you don't care about the price, you can get shares immediately (assuming the stock market is open). Mutual fund orders all execute once per day, no matter when they're placed, so the shares won't be added to your account as quickly.
How old do you have to be to invest in stocks or mutual funds?
Only adults can invest, which in most cases means you'll have to turn 18 before you can invest on your own. Those who aren't yet of age can invest with the help of a trusted adult through a custodial account. Custodial accounts are technically a minor's property, but they don't have direct access to the account until they become an adult.
Marketplace. "5 Things You Need to Know About Lehman Brothers."
Securities and Exchange Commission. "Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing."
SEC Office of Investor Education and Advocacy. "Mutual Funds and ETFs: A Guide for Investors."
SEC Office of Investor Education and Advocacy. "Mutual Funds and ETFs: A Guide for Investors," Page 21.
Internal Revenue Service. "Mutual Funds (Costs, Distributions, etc.)."
SEC Office of Investor Education and Advocacy. "Mutual Funds and ETFs: A Guide for Investors," Page 36.