Mutual Funds vs. Stocks

Some debates have no set answer, like which band was better – The Beatles vs. The Rolling Stones?

Stocks vs. Mutual Funds isn’t quite as captivating, if for no other reason than watching a stockbroker crunch numbers isn’t as entertaining as watching Mick Jagger do his thing. But the debate could be crucial to your financial health.

Should you invest in stocks, or put your money into mutual funds?

Let’s start with the basics. A stock is a share of ownership in a single company. Mutual funds are a collection of investments – stocks, bonds, and other securities – in a single fund.

Both come with real money-making potential, and both have money-losing risks. Like the Beatles-Stones question, the answer is up to each individual investor.

Here’s what you should know in the search for the right answer for you.

» Learn More: Should You Invest or Pay Off Debt

Stocks vs. Mutual Funds

Most companies start as private enterprises, then “go public” when they join the stock market and let investors buy into them. A stock is a piece of that company. Its price is determined by supply and demand.

If the company grows and there’s a demand for shares, the price goes up. If people don’t think the company is a good investment, the stock price goes down.

A mutual fund is what the name suggests. You and other investors pool your money to mutually buy stocks, bonds, and other securities. Mutual funds are run by professional money managers who decide which securities to buy and when to sell them.

Diversifying your portfolio spreads out the risk. If one stock is a loser, another one can mitigate the damage.

Pros and Cons of Stocks

Stocks, which are also called “equities,” are a real risk/reward proposition. They offer a lot of revenue potential, but you can lose your shirt (and a lot more) if you don’t invest wisely.

Pros

• Get rich quick! That’s not likely, but there are opportunities to make sizable short-term gains. For instance, GameStop stock was selling at $17.25 a share at the start of January 2021. Due to manipulations so crazy Hollywood’s made a movie about it (“Dumb Money”), the stock shot to $354.
• Easy to trade. An account can be opened in a few minutes, and it doesn’t take much money to get started. Some online brokers now offer fractional shares of stocks, which allow you to invest as little as $1 in a portion of a share.
• Long-term security. You don’t need a share of GameStop to make a nice return. What you really need is patience. The average annualized return of the 500 largest companies listed on the stock exchange (the S&P 500) is 9.1% over the past 150 years.
• Low trading costs. A lot of brokers don’t even charge trading fees for individual stocks.

Cons

• Potential for large losses. Stocks historically offer long-term security, but past performance does not guarantee future results. A stock market crash could devastate your financial health, or worse. Legend has it that investors were jumping off Wall Street buildings after the 1929 stock market crash. Historians dispute that, but it makes a nice cautionary tale.
• Stock market gains are taxable. Rates vary depending on a number of variables. But rest assured, the IRS will eventually get its cut.
• It’s time consuming. Picking stocks is not like throwing darts against a board. It requires a lot of research. And even then, there’s no guarantee you’ll hit your target.
• Investing in stocks can feel like gambling at a craps table. There’s a lot of anxiety as you helplessly watch the dice tumble. Know your risk tolerance before playing the game.

Pros and Cons of Mutual Funds

Mutual funds offer a lot of advantages, but they are far from fool-proof. Here are factors to consider.

Pros

• Expert handling. A professional portfolio manager will make the investment decisions. His or her job depends on getting it right.
• Instant diversification. Most mutual funds invest in dozens and sometimes hundreds of different securities. Variety means less risk and volatility.
• Nice returns. Large-company stock mutual funds have produced returns of up to 12.86% over the past 20 years.

Cons

• Management fees can add up. Some funds charge 1% of your annual investment. If the expense ratio is more than 1.5%, look around for a better deal.
• The IRS strikes again. When a fund realizes a gain from selling assets, you could owe capital gains taxes even if you haven’t sold any shares.
• There’s no guarantee an actively managed mutual fund will outperform the market, and you could even lose money.
• High cost of entry. Many mutual funds require an initial investment of $500 to $5,000.

Stocks vs. Mutual Funds – Factors to Consider

Stocks are riskier, but the chances of a big return are greater. Mutual funds seldom produce spectacular gains, but they rarely bottom out. Here are some specifics to consider when choosing one over the other.

Risk/Reward

Remember Blockbuster? If you owned stock in the company, you probably do. And not in a good way.

It was the go-to movie rental business in the 1990s and early 2000s and traded for $10.65 a share in 2005. Then along came Netflix and the streaming revolution. Blockbuster’s 1,700 stores turned into small ghost towns and the company filed bankruptcy in 2010.

If you’d invested your life savings in Blockbuster, you might currently be living under a bridge. But if you’d bought a mutual fund that contained Blockbuster stock, the fund manager probably unloaded the Blockbuster stock and replaced it with stock from growing retailers.

You would have gained or lost some money based on the manager’s picks, but the mutual fund overall would have performed much better than Blockbuster stock alone.

That said, stocks offer big rewards. Vaccine maker Moderna’s stock was losing almost $2 a share in early 2020. Along came Covid, and Moderna stock shot to $28.29 a share in 2021.

Good mutual fund managers might have foreseen vaccine stocks would rise, but they would not have shifted their entire portfolios to one company.

Age

Age is not just a number when it comes to financial planning. It should determine much of your investment strategy.

When you are young and have decades before retirement, stocks have more appeal. They certainly go up and down but tend to grow more quickly over time.

Bonds don’t fluctuate as much. As you age, it makes more sense to shift to bonds since you will probably have to sell assets in retirement and want to limit your exposure to downturns.

Age-based mutual funds have gotten more popular, especially with younger workers investing in employer-owned 401(k) plans. Age-based strategy is also common in 529 college funds.

If you start an account for a 3-year-old, the money will be invested in a portfolio containing mostly stocks. As the child ages, the fund will gradually move to less risky investments, helping ensure that the money will be available when it’s needed.

Time for Research

All investments require research, but stocks demand the most. A manager handles that with mutual funds because most individual investors don’t have the time or expertise to do the job.

But choosing a mutual fund itself requires research. Here are factors to look for:

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

There are numerous strategies. Some fund managers invest in small-cap stocks, others in blue-chip stocks. Some prefer older, proven stocks. Others lean toward newer stocks with high payoff potential and risk. Read the fund prospectus or consult a financial adviser if you need more guidance.

If you buy individual stocks, follow them closely. Read as much as you can and ask for updates if you have a stockbroker.

Fees

Unless there’s a stockbroker in your family, there’s pretty much no such thing as free help. You will likely pay the broker an advisory fee and a commission when you sell the stock, though that practice is waning.

Mutual fund fees are practically invisible. Funds typically charge sales commissions, management and advertising fees and other operating costs. These are grouped into “expense ratios” and reduce share value. Investors should look for strongly performing funds with low investment ratios.

Diversification

The more companies you invest in, the less likely you’ll get wiped out financially. Mutual funds diversify by design. The way that’s done is up to you.

If you can tolerate a lot of risk, you might have a portfolio full of tech stocks. If you’re risk averse, you might favor an assortment of bonds.

Financial experts advise owning at least 15 individual stocks to reduce risk. Fewer than that, and you could take a financial bath if one or two stocks tank. Most investors mix stocks and bonds, or they invest in a variety of business sectors.

Capital

The amount of money you have to invest is called capital. If you’re just starting to invest through a 401(k) plan at work, consider focusing the stock funds on your company’s plan.

Older or more wealthy investors 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.

What About Exchange-Traded Funds (ETFs)?

Exchange-Traded Funds are similar to mutual funds. The main differences are how they are managed.

Brokerages that create mutual funds directly control their shares. When you buy mutual fund shares, you buy from the brokerage. When you sell, you sell the shares back.

Mutual funds are managed and employ stock analysts, marketing departments, etc. Fees are charged to cover those costs.

Though EFTs manage the number of outstanding shares to correspond with market conditions, they are part of most stock trades. Investors trade EFTs among themselves on stock exchanges, making the transactions less costly than mutual funds.

Like mutual funds, EFTs control the number of outstanding shares to correspond with supply and demand in the market.

EFTs trade like stocks, so their price changes during the day. The price of mutual funds is set daily. If you want to sell an EFT, the price is what it is the moment you sell. The price of a mutual fund share is set at the end of the trading day.

Though mutual funds and EFTs have a lot in common, EFT’s lower management costs make them popular with many investors.