Choosing between individual stocks and mutual funds can be difficult, especially if you are a novice investor. Both investment options are extremely popular and have their own advantages and disadvantages.
So, which is the better choice? Let’s take a look.
A stock is a type of investment which allows you to own a piece of a company. Stocks are issued by companies for the purpose of raising funds to expand their operations.
When you buy a company’s stock, you actually become a part-owner who is eligible to receive a proportionate share of the company’s earnings, known as dividends.
There are two ways in which you can make money from the stocks you own.
If the price of the stock you own increases, you can sell it for a profit. You can calculate your profits by subtracting the buying price and the transaction fees from the selling price.
But you don’t need to sell to make money. Many companies share a portion of their profits with their shareholders by paying quarterly or yearly dividends.
These dividend payments can serve as an additional source of income for you. Alternatively, you can choose to reinvest the dividends to buy more shares of the same company as well.
You can buy and sell stocks through a licensed stockbroker. Typically you have to pay a fee for every trade, whether you buy the shares of a company or sell the ones you own.
What is a mutual fund?
A mutual fund, on the other hand, allows you to invest in a wide variety of asset classes. Mutual funds collect money from individual investors and invest in equities, bonds, and money market instruments.
Funds are managed by investment professionals who are responsible for achieving the stated investment objectives of the fund.
Mutual funds can be broadly classified into two types — actively managed funds and passively managed funds.
- Actively managed funds are operated by money managers who try to outperform the market and get higher returns on the investment.
- Passively managed funds are designed to track and mimic the performance of a market index. Since these funds are not operated by money managers they tend to be far less expensive than actively managed funds.
There are three ways in which you can make money from a mutual fund.
Increase in net asset value: If the securities in which a fund has invested in perform well, the net asset value (NAV) of the fund increases. If you decide to sell your shares when the fund’s NAV is on the rise, you can make a profit.
Capital gains: When the fund manager sells a security which has considerably increased in value, the profits resulting from the sale – commonly referred to as capital gains – are distributed among the investors. Mutual funds generally distribute capital gains among their investors on a yearly basis.
Dividends: When a mutual fund earns interest or receives dividends from the investments it has made, it distributes a portion of the income to investors. You can choose to receive the dividends directly in the form of payments or reinvest the money in the fund.
Comparing stocks and mutual funds
Diversification: In order to build a truly diverse stock portfolio, you need to buy the shares of at least 15 to 20 companies operating in different sectors and industries.
You can achieve the same level of diversification by investing in a single mutual fund, as the fund tends to invest in a variety of different securities.
Risks involved: Investing in individual stocks is inherently risky, as your investment can plummet in value if the company does not perform well.
The risks associated with investing in a mutual fund are lower as the fund tends to invest in a variety of different stocks.
Income potential: When it comes to individual stocks, the returns on your investment are entirely dependent on the company’s performance.
- If the company you becomes much more valuable you can probably retire early.
- If it performs reasonably well, you can make a profit by selling your shares.
- If it performs poorly or goes out of business altogether, you could lose part or all of your investment.
Because it’s impossible to predict which outcome is most likely, experts say that you should invest in a wide variety of stocks rather than putting all your eggs in one basket.
When it comes to mutual funds, the returns are dependent on how well the fund is managed (in case of actively managed funds) or how well a market index performs (in case of passively managed funds).
Due to the diversified nature of the investments, mutual funds generally tend to offer steady returns in the long term.
Liquidity: Individuals stocks are highly liquid in nature. You can buy or sell any stock, any time you want. In fact, there are day traders who make money on a daily basis by buying and selling shares multiple times a day.
Mutual funds, in comparison, are less liquid, as they are traded only once a day.
Control over investment: With individual stocks, you have complete control over your investments. You get to decide everything – which stock to buy, when to buy, and when to sell.
With mutual funds, you have no control over your investment, as the decisions are made by the fund manager.
Expenses: With individual stocks, you have to pay a commission or transaction fee only when you buy or sell a stock. There are no ongoing costs at all.
With mutual funds, you have to pay an annual expense ratio, which is the cost of managing the fund. It needs to be paid irrespective of the fund’s performance. In addition to it, you have to pay a sales load every time you buy or redeem your shares.
Investment management: Managing a stock portfolio is not easy and requires a great deal of your time and effort. You need to keep track of each stock’s performance, buy and sell stocks at the right time, and keep a close eye on the economic indicators.
Mutual funds, on the other hand, are professionally managed, which means you do not have to spend hours on end reading financial reports and watching business channels.
Which is the better choice for you?
If you have a knack for picking stocks, and if you can afford to spend a considerable amount of time studying and tracking the market, it might be a good idea for you to invest in individual stocks.
Otherwise, mutual funds are clearly the better choice. They are less risky, easier to manage, and give stable returns on a consistent basis.
If you are totally intent on investing in stocks, you can buy a handful of blue-chip stocks and dividend paying stocks and invest the rest of your money in index-traded and exchange traded funds.