Stocks vs. Mutual Funds
As an investor, you may be asking yourself which one of these investing options is the better choice. Well, the short answer: it depends on what you’re looking for.
Both individual stocks and mutual funds offer different types of pay-offs and risks, advantages and disadvantages. Before you start investing money in either of these options, it’s important you know what you’re getting into first.
Mutual funds are investment portfolios that attempt to strategically diversify in an effort to minimize risk by holding individual securities in a variety of different markets and industries. Many have deemed them a sort of “done-for-you” diversification tool. That being said, even though mutual funds are the primary tool used by the majority of investors today, like any investment, there’s both good and bad traits to keep in mind.
Distributing risk across a variety of markets and industries is one of the great strengths of mutual fund investing. By utilizing a fund, an investor can immediately diversify their investment exposure regardless of dollar amount. Additionally, mutual funds can be considered a form of passive investment. Rather than being saddled with the burden of monitoring each individual security in your portfolio, you’re able to transfer that responsibility to the fund manager… in exchange for a small fee of course. That being said, mutual funds are ideal for beginning investors looking to get their feet wet or for those who would like to take a more “hands-off” approach to investing.
For the most part, the majority of mutual funds are designed to achieve favorable performance “RELATIVE TO” the market. This means, despite the additional fees and professional management of the assets, that your portfolio is designed to likely do nothing more than track the market. Meaning if the markets are up, so are you… and that’s a good thing. But, unfortunately, that also means when the markets are down… you are as well… and that’s decidedly not a good thing.
That being said, in most instances it’s not the fund manager’s fault. They’re simply restricted by the confines of the prospectus. (That thick booklet you receive when you invest in a fund.) Upon examination, you’ll find that most retail investment funds are required to remain – on average – about 80% fully invested regardless of market conditions, which means if the S&P 500 Large Company Stock Index is declining, and your large company stock mutual funds must remain at least 80% invested in this sector – short of selling out of the funds in an attempt to time the market – there’s nothing either you or the manager can do to avoid a similar decline in your portfolio. Something to keep in mind as you consider your options.
Stocks, on the other hand, provide a more targeted investment option. Of course they have their good and bad qualities as well.
The primary benefits that draw most investors to selecting individual stocks is the ability to not only experience the thrill of direct ownership in the company, but, on a more practical level, the prerogative to sell at will throughout the trading day. Mutual fund trades, on the other hand, only settle at the close of business regardless of when you place your sell order. This means you could elect to cash out of your fund at 10:30 AM due to a declining market, yet not actually be out of the fund until 4:00 PM when the market closes. (ETFs are another story…but that’s a different post.)
Therefore, individual stocks are much more flexible for those seeking to “play the market.” Which brings up another benefit of owning stocks…managing taxes on gains. Unlike mutual funds that trigger tax on gains realized due to regular buy and sell activity throughout the year, stocks only trigger tax upon liquidation. Something to consider if you’re investing assets outside of a tax-sheltered retirement account.
Then of course there are dividends. For many investors, this is the primary reason for owning stocks. How many of us had grandparents or parents that regularly received dividend checks from companies like General Electric, American Airlines, or AT&T? Not only did they arrive like clockwork, but they were also taxed at the lower rate of 15% or 20% depending on your marginal bracket. That being said, while selecting individual stocks can have big pay-offs, they also have big risks as well.
The primary downside to owning individual stocks is also the primary benefit to owning mutual funds… diversification. Or in the case of owning an individual company rather than several within a fund… LACK of diversification. While funds seek to minimize risk by spreading your money over many companies, should your stock experience a 50% decline, there’s nowhere to run for cover.
Developing your own investment portfolio is not a task to be taken lightly.
The great advantage of mutual funds, the built in risk minimization feature, can also be replicated in individual portfolios, but it takes a keen market savvy and a great deal of regular attention to how markets are performing to keep up. You should be mindful of this if you are considering managing your own portfolio by investing a good deal of capital in stocks. One volatile day in the markets could cost you big, otherwise.
If you’re unsure about which option might be best for you, consult with a financial advisor who will be able to help you assess the current state of your finances, gauge your risk tolerance, and develop an investment strategy that fits your personal goals.