How to Decide Between Stocks and Mutual Funds

Trading stocks has never been cheaper. Most brokerages no longer charge the hefty sales commissions once tacked on to online trades and many have erased maintenance fees on retirement accounts.

Mutual funds are another story. Many add commissions, called loads, to purchases and can siphon off income through management fees built into their operating costs.

So, stocks are a better deal than funds, right? For most people, that answer is wrong, and risk is the reason.

Buying an individual stock is a calculated gamble. To do it right, you need to understand the sector – for example, energy or finance – and then dig into the company itself.

• Does it have a compelling story?
• Are its financial results promising?
• Do its competitors pose a threat?
• Does it face regulatory obstacles?

You get it. There are a lot of variables, only some of which are revealed in required financial filings.

Many times, a stock plunges on bad news, catching even experienced and well-informed traders by surprise. Other times, they are richly rewarded with good news like a product breakthrough that promises to yield huge profits for the company.

Mutual funds are different. They usually contain stocks or bonds from a large number of companies. Frequently, they focus on sectors, but often they use other metrics. Some invest in blue-chip companies, others in emerging markets, others in industries or segments of industries and still others in various bonds. Some of today’s most popular mutual funds hold stock in financial indexes, such as the Standard & Poor’s 500.

Most investors today enter the stock market by saving through retirement accounts, especially employer-sponsored 401(k)s. Most retirement accounts are structured to make investing simple. A typical 401(k) might contain a limited assortment of mutual funds and employees are allowed to allocate withheld wages to one or more of the options.

Key Factors to Consider

If you are torn between buying blue chip stocks or mutual funds, you need to consider your objectives and your tolerance for risk. Risk is implicit in all financial investments. The chances of a big return are greater with stocks, but so are the chances of severe losses.

Mutual funds seldom produce spectacular gains, but just as seldom do they bottom out.

In general, the more diversified your holdings, the greater the chance for long-term gains.

Risk/Reward

Individual stocks, even if they are attached to large companies, are generally riskier than mutual funds. Consider an investor who held a large amount of stock in storied retailer Sears. A generation ago, Sears was a solid investment. Then the retail world changed with big-box discounters like Walmart and on-line vendors like Amazon altered the way people shop. Gradually, Sears declined, closed thousands of stores and eventually filed bankruptcy in 2018.

If you bought Sears stock 20 years ago and never sold it, you lost your investment. However, you could have bought a mutual fund that contained Sears stock as part of its portfolio and still done quite well. The fund might have held a large amount of Sears at one point, but chances are the fund manager began unloading and replacing it with stock from growing retailers over the years. You might have gained or lost some based on the manager’s picks, but chances are the mutual fund performed much better than Sears itself.

But stocks can offer big rewards too. When Facebook made its first public offering of stock in 2012, its shares traded at $38. In late 2019, the stock was trading at nearly $200. Again, if you buy a winner the rewards can be huge, but few people only buy winners.

Age

You should consider your age when buying stocks or mutual funds, though it shouldn’t be an overriding factor. In general, when you are young with several decades ahead before retirement you might be wise to own more stocks, also called equities, and fewer bonds. The value of equities tends to grow more quickly over time, but they are also riskier. Bonds usually have fixed payouts over time and tend to fluxuate less in value. The older you are, the more you might want to shift from stocks to bonds since you will probably need to sell assets in retirement and you want to limit your exposure to downturns in the financial markets.

Aged-based mutual funds have grown in popularity in recent years, especially among younger workers investing in employer-sponsored 401(k) plans. These funds evolve as you age, moving from higher risk, investments with potentially high returns to less risky, slower growth investments as your age. These funds are usually marketed with target retirement dates.

The age-based strategy is also common in 529 college savings plans. These funds, which grow tax free, also use a target date. If you start an account for a 3-year-old, the money will be invested in a portfolio containing mostly equities. As the child ages, the fund will gradually move to less risky investments, helping ensure that the money will be available when it is needed.

Time for Research

All investments require research, but stocks (equities) demand the most. Since mutual funds are essentially baskets of stocks and bonds and have managers who are constantly monitoring their performance, you don’t pick individual stocks and bonds. The same is true of index funds. People often buy funds by sector. If you think biotech stocks will perform well but you don’t have the time, expertise, interest or risk tolerance to invest in individual companies, you might choose a biotech mutual fund.

Mutual funds slice and dice the market is many ways.

Research should include:

• How the fund has performed
• How it is managed
• What fees it charges
• What the future is likely to hold

Some funds invest in small-cap stocks, others in blue chips. There are seemingly endless strategies. Some have existed for decades; others are very new. You can read fund prospectuses or consult a financial adviser if you want to learn more.

As mentioned earlier, if you buy individual stocks, you should follow your investments closely. Some are very stable, but others are very sensitive to news or they have management changes that impact their value. Again, read as much as you can and, if you have a stockbroker, ask for updates.

Fees

Many investments come with fees. If you invest in individual stock but rely on a stockbroker to manage your portfolio, you will probably pay the broker an advisory fee. You might pay commissions when you buy and sell stocks, but these are becoming less common.

If you invest in mutual funds, fees are essentially invisible. You can find fee information, called the expense ratio, when you research the fund. Funds typically charge sales commissions, management and advertising fees, and other operating costs.  These are grouped into what is called expense ratios and reduce share values. Many investors look for strongly performing funds with low expense ratios.

Diversification

Investors usually try to spread risk by owning an assortment of stock. If you put all your money in a single stock and its value collapsed, you could lose your money. The more companies you invest in, the less likely you’ll suffer a financial catastrophe.

Mutual funds do this implicitly, since they often contain scores of stocks.

The way you diversify is up to you. If you have a high-risk tolerance, you might have a stock portfolio filled with an assortment of tech stocks. If your risk-tolerance is low, you might want to hold an assortment of bonds.

Financial experts often advise owning at least 15 individual stocks in a diversified portfolio to reduce risk. Fewer than that and a downturn in a single stock could be damaging.

Most investors mix stocks and bonds, or they invest in funds with holdings in different sectors. A trustworthy financial advisor can help you build a diversified portfolio.

Capital

The amount you’re able to invest is called capital and how much capital you have determines what you can buy. If you are just beginning to invest through a 401(k) at your first job, you might want to focus on several stock funds contained in your company’s plan. The focus is often growth at this point. Investors who are older and wealthier often spread their money across many investments, including stocks, bonds, funds, real estate and even artwork. As long as it’s done wisely, greater diversity means greater financial security.

Difference Between Stocks and Mutual Funds

Stocks and bonds can be owned individually or are purchased in groups through mutual funds or exchange traded funds. Think of owning individual stock like owning several rental apartments and managing them yourself. You need to find tenants, make repairs, collect rent and keep an eye on the real estate market if you plan to sell at some point. It’s time consuming.

Buying a mutual fund is like hiring a company to manage the apartments. You just need to track the value of the investments, pay a management fee and remember the tax bill.

What Is a Stock?

A stock is an investment in a company. Companies issue stock to raise capital, and those who buy the shares collectively own the company. The value of a stock changes over time, often as a result of the company’s financial current or projected performance, but there’s no formula that can accurately predict stock prices. Stocks are traded on exchanges and, in the end, the value of a stock is what a buyer is willing to pay for it.

Investors use different strategies when buying stocks. They sometimes focus on a company’s growth potential or lack of it. If a company is about to release a new product that is greatly anticipated, its stock price often rises. If the same company is hit with a potentially devastating lawsuit, its stock might plunge. There are many aspects of a company that capture investor interest, and the market value can shift rapidly, often on rumors.

Investors buy stocks to make money. They can do this if the value of a stock rises from the purchase price to the sales price. They can also earn dividends – money the company distributes to shareholders from its profits. Not all companies pay dividends, especially not those that are growing rapidly and investing their profits into expansion. Investors often divide companies into two camps – growth companies where the money is made buying shares at a low price and selling them at a much higher one, and dividend companies whose stock might not gain value quickly but who pay substantial dividends.

Of course, not all stock rise and some stop paying dividends. Investors need to monitor company performance or risk selling at a loss.

What Is a Mutual Fund?

Mutual funds are large portfolios of stocks and bonds. Financial services companies manage the portfolios, buying and selling individual stocks over time. They then sell shares in portfolios, called funds, to investors. The funds make money from the fees they charge investors and the investors benefit from the investment diversity the funds provide. Funds greatly reduce the risk of owning individual stocks.

Mutual funds come in two primary flavors. Actively managed funds have managers who buy and sell the investments the fund holds. They receive a fee for this, one that is pulled from the fund. Fees vary, but they impact investor returns.

Passively managed funds don’t have investment gurus. Instead, they track indexes, measurements of how stocks of various descriptions are performing. If you know about the Dow Jones Industrial Average, you are familiar with one widely followed index. A mutual fund that tracks the Dow is invested in the index’s 30 stocks and its value will rise and fall according to the Dow’s performance. No one makes decisions. The more investors buy shares in the fund, the more shares the fund buys in the Dow.

Mutual funds often pay dividends on specified dates during the year and, if they make money from selling their stocks and bonds, they also make capital gains distributions to their investors.

Investors can buy mutual fund shares directly or through vehicles like IRAs, Roth IRAs or employer 401(k) plans. Investors who own their shares directly must pay taxes on the money they receive from capital gains distributions and dividends. Those why buy their funds through tax-advantaged retirement accounts don’t pay taxes on gains or dividends as long as they keep the money in their accounts.

A Middle Ground: Exchange-Traded Funds (ETFs)

Mutual funds and exchange traded funds are very similar in many ways. Both hold large numbers of shares in specialized categories. ETFs often invest in indexes just like index mutual funds. The difference in how they are managed and traded.

The brokerages that create mutual funds directly control their shares. If you buy mutual fund shares, you buy them from the brokerage and when you sell, you sell the shares back. Most funds are actively managed, creating an assortment of costs. Actively managed funds employ stock analysts and marketing departments, charging fees to cover costs and pay salaries.

ETFs operate differently. Though they manage the number of outstanding shares to correspond to market conditions, they aren’t part of most stock trades. Investors trade ETFs among themselves on stock exchanges, making the transaction costs lower than mutual funds. Like mutual funds, ETFs control the number of outstanding shares to correspond to supply and demand in the market.

Another difference: ETFs trade like stocks, so their price changes during the day. The price of mutual funds is set daily. If you want to sell an ETF, the price is what it is in the moment you sell it, while the price of a mutual fund share is set at the end of the trading day.

Though ETFs and mutual funds have many similarities, the ETFs’ lower management costs make them popular with many investors.