Source: Dates
Table of Contents
- Introduction
- What are Mutual Funds?
- What are Stocks?
- Key Differences Between Mutual Funds and Stocks
- Pros and Cons of Mutual Funds
- Pros and Cons of Stocks
- Which is Better for Different Investment Objectives?
- Mutual Funds vs Stocks — The Verdict
- FAQs
Introduction
“Should I invest in mutual funds or stocks?” is a common dilemma faced by new and seasoned investors alike. On one hand, mutual funds offer diversification and professional management. On the other hand, stocks provide the potential for higher returns. So which is the better choice overall?
This comprehensive guide examines the key differences, pros, cons, and use cases for mutual funds versus stocks. Read on to learn which asset class may be more suitable for your investment goals and risk tolerance.
What are Mutual Funds?
A mutual fund is a professionally managed investment vehicle that pools money from many investors to purchase a diversified portfolio of stocks, bonds, and other securities. The fund’s assets are selected and managed by a fund manager or management team.
Mutual funds offer built-in diversification, as generally 100+ stocks or bonds are held within a single fund. They also provide convenience, as the fund managers handle security selection and portfolio rebalancing.
In terms of costs, mutual funds charge an expense ratio yearly fee that averages around 0.5–1%. There are typically no upfront commissions. Most funds can be purchased directly from investment companies or via retirement accounts like 401(k)s and IRAs.
What are Stocks?
Stocks, also called equities, represent ownership in a public company. When you purchase shares of common stock, you become a partial owner entitled to potential financial gains like dividends and price appreciation. However, stock investing comes with the full risk that share prices could also decline.
Unlike mutual funds, buying stocks provides direct control over your holdings. You get to pick individual stocks to create a customized portfolio aligned with your outlook on companies and sectors. However, stock investing requires much more research, analysis, and monitoring than mutual funds.
Transactions costs are also a factor with stocks. Commissions, trading fees, bid-ask spreads, and capital gains taxes can eat into returns, although these have declined with the rise of online/discount brokers and commission-free trading apps.
Key Differences Between Mutual Funds and Stocks
Below is a quick overview of how mutual funds and stocks stack up across some key factors:
| Mutual Funds | Stocks | |
|---|---|---|
| Diversification | High — Holds many securities | Depends on portfolio — Can be high or low |
| Control over holdings | Low — Managed by professionals | High — Investor selects specific stocks |
| Potential returns | Varies — Historically lower than stocks | Varies widely — May be negative or exceed 20% |
| Risks | Lower than individual stocks | Moderate to very high |
| Liquidity | High — Shares redeemable daily | Depends on market and volume |
| Investment costs | Expense ratio only — No commissions | Commissions, bid-ask spread, fees |
| Investment minimums | Often $1,000-$3,000 | As low as $0 up to $10,000s per stock |
As shown above, mutual funds offer built-in diversification, lower costs, professional management, and high liquidity. Meanwhile, stocks provide more potential upside and direct control over your holdings at the cost of higher volatility and investment expenses.
Next, let’s dive deeper into the notable pros and cons of each option.
Pros and Cons of Mutual Funds
Pros:
- Diversification: Mutual funds provide exposure to dozens or hundreds of different securities across various asset classes, market caps, sectors, and geographies. This minimizes portfolio volatility and risk.
- Professional management: Fund managers and analysts handle security selection, weighting, rebalancing, and portfolio strategy. This can be a major benefit for hands-off investors.
- Low costs: Mutual funds have no upfront commissions and have expense ratios under 1% on average. This improves net returns compared to stock trading fees.
- Liquidity: You can typically cash out mutual fund investments at the end of any trading day at that day’s NAV price. This provides flexibility to exit positions as needed.
- Tax efficiency: Managers can harvest tax losses and minimize capital gain distributions compared to individual taxable stock trading.
- Simplicity: Investing in mutual funds is easier than picking individual stocks, especially for beginners. Just choose a few funds to create a balanced portfolio.
Cons:
- Mediocre returns: The average actively managed mutual fund underperforms index funds and the overall stock market over 10+ year periods.
- No control: You rely on the fund manager’s stock picks instead of tailoring investments to your own strategy and preferences.
- Costs add up: While expense ratios seem small, they compound over decades to meaningfully reduce total gains.
- Overdiversification: Holding too many positions can lead to benchmark-like returns rather than market-beating gains.
- Style drift: A fund’s holdings and risk profile may shift over time based on management’s evolving investment strategy.
- Taxable events: Rebalancing and fund manager trades can trigger capital gains taxes for non-qualified accounts.
Pros and Cons of Stocks
Pros:
- Unlimited upside: Individual stocks have no capped return potential. Outsized gains are possible if you pick winning companies.
- Full control: You decide which stocks fit your investing style, objectives, risk tolerance, and beliefs about growth opportunities.
- Targeted exposure: Stocks allow you to fine-tune exposure to specific sectors, industries, or trends.
- Low costs: With $0 commission trading platforms now commonplace, stock trading is very affordable.
- Tax advantages: Careful loss harvesting and holding periods over a year produce favorable long-term capital gains tax rates.
- High liquidity: It’s easy to buy and sell most stocks any time the market is open. Large-cap stocks see tens of millions of shares traded daily.
Cons:
- Concentrated risk: Just a few stocks can greatly sway portfolio performance due to lack of diversification across sectors and asset classes.
- Volatility: Individual stock prices fluctuate more than the market as a whole, increasing short-term risk.
- Higher taxes: Short-term capital gains under one year are taxed as ordinary income, which is a higher rate than long-term stock gains.
- Time-consuming: Picking stocks takes much more research and monitoring than mutual funds to try achieving excess returns.
- Behavioral biases: Emotions like fear and greed can lead to costly stock trading mistakes for individual investors.
- Low liquidity risks: Thinly traded stocks like micro-caps may be difficult to buy and sell without substantial slippage.
Which is Better for Different Investment Objectives?
The best choice between mutual funds versus stocks depends partly on your timeline, goals, risk appetite, and desired involvement as an investor. Consider the following general guidelines:
Mutual funds tend to be better for:
- Retirement investing
- Preserving capital or generating income
- Beginner investors new to stock research
- Slow and steady portfolio growth over decades
- Hands-off investors who value automation
Stocks tend to be better for:
- Hitting home run returns with a few top picks
- Constructing a custom portfolio aligned to your outlook
- Maximizing long-term capital gains tax rates
- Accelerating portfolio growth rapidly
- Investors who enjoy picking and trading stocks
Of course, the two assets can complement each other nicely in a well-balanced portfolio. Mutual funds serve as the diversified core holdings, while stock positions provide satellite riskier assets with home run potential. Rebalancing between the two over time helps manage overall portfolio volatility.
Mutual Funds vs Stocks — The Verdict
So in the great debate between mutual funds versus stocks, which option emerges as the winner?
The truth is that neither is absolutely better or worse than the other. The most suitable investment depends on your specific goals, stage of life, desired involvement, and abilities as an investor.
For hands-off investors who prioritize low costs, diversification, and professional management, mutual funds are likely the better choice. The convenience and automated investing benefits are hard to beat.
Meanwhile, stocks are ideal for investors who want greater direct control, don’t mind frequent research and trading, and are aiming for potentially market-beating returns on their highest conviction picks. Just be prepared to weather higher volatility in pursuit of those excess gains.
Ultimately, owning a mix of both mutual funds and stocks allows investors to capitalize on the strengths of each asset class within an intelligently allocated portfolio. As with many personal finance topics, moderation and balance is the wisest approach.
FAQs
Are mutual funds riskier than stocks?
No, mutual funds are generally less risky than owning individual stocks since they provide instant diversification across many securities. However, certain sector mutual funds that concentrate in risky assets like biotech or emerging markets can be riskier than broad-based stock index funds.
Do mutual funds perform better than stocks?
On average, mutual funds slightly underperform the overall stock market benchmark due to their expense ratios weighing on net returns. However, some actively managed mutual funds do outperform over certain periods. Index funds and ETFs that simply track the market tend to outperform most active mutual funds over full market cycles.
What is the minimum investment for most mutual funds?
The minimum initial investment is typically $1,000 to $3,000 for most mutual funds. Some funds have higher minimums of $10,000 or more. But many fund families offer ways for new investors to start with just $100 to $500 if investing through a Roth IRA or automated periodic purchase plan.
Can mutual funds be traded daily like stocks?
Yes, the shares of open-end mutual funds and ETFs can be bought and sold daily during market hours at that day’s net asset value (NAV). Their liquidity is one of the appeals of mutual funds over less liquid securities.
Which is better for long-term investing?
Historically, stocks have generated the greatest compound average returns over multi-decade periods. But mutual funds offer lower volatility and higher certainty of positive long-term returns. So a mix of both mutual funds and stocks is ideal for most long-term investors.
