Mutual Funds vs. Stocks: How Should You Invest?
If you’re just getting started as an investor, you might wonder whether you should invest in mutual funds or stocks. Both have their good and bad points. Mutual funds are probably less risky, but stocks have the potential for bigger returns. If you’re unsure about the difference between mutual funds and stocks, keep reading to learn more.
Mutual Funds vs. Stocks
The main difference between a mutual fund and a stock is that the former gives you investments in numerous companies, and the latter gives you an investment in only one.
A mutual fund pools money from many investors and uses it to buy shares of stock, bonds and other investments. The investors receive shares of the mutual fund relative to the amount they invested. Each share represents a part of the combined “basket” of investments.
Stocks are shares in individual companies. When you buy a stock you are buying a piece of the company, which means you’re a shareholder. Stocks are sometimes referred to as equities.
| Stocks | Mutual Funds | |
|---|---|---|
| What It Is | A share of an individual company. As a shareholder, you can make money by selling the stock at a profit, or by getting a dividend. | A share of a fund that consists of a basket of different investments. The investments might be chosen to represent a particular sector or to balance gains and losses. |
| Who It’s Best For | Investors who want potentially lucrative financial gains in the form of a rising stock price and/or dividends, as well as those who want voting power within the company. | Those who want someone else to make their investment decisions. Most mutual funds are managed by professional fund managers who decide which stocks, bonds and other investments to buy and sell. |
| Costs and Fees | You pay a trading fee when you buy and sell shares. When you sell, you will pay capital gains taxes on appreciation in the price. | You might pay sales charges when you buy or sell shares, and you will pay management fees. Because mutual fund managers buy and sell positions within the fund, you might pay capital gains taxes even if you hold the fund. |
| Risk and Return | When you buy a single stock, you’re betting on the success of that particular company. You’ll typically make a profit if the company does well and lose money if it doesn’t. | Mutual funds are diversified, so they are inherently less risky than individual equities, but they can still lose money. Their gains and losses tend to be smaller than stocks’. |
| Learn More | How To Invest In Stocks: A Beginner’s Guide | Mutual Funds: Everything You Need To Know |
Pros of Mutual Funds
Investing in a mutual fund has some advantages over investing in individual stocks. Here are four important benefits:
- Diversification: Because a mutual fund holds different kinds of investments — stocks, bonds, cash and/or alternative investments — investors are somewhat protected from the volatility of the general market. For example, stock prices often rise as bond prices fall, and vice versa. An investor who holds a mutual fund that includes both stocks and bonds will see falling stock prices offset by rising bond prices, and therefore will not lose as much as someone who is invested only in stocks.
- Professional management: Mutual funds have professional managers whose job is to choose the best stocks, bonds and other investments. These experts research investments to select the best ones and then monitor their performances. Some mutual funds, called index funds, don’t have professional managers but instead track the investments in an index, such as the S&P 500.
- Time: Because a professional manager monitors the fund, you don’t have to spend your own time looking at stock websites and company news to make investment decisions yourself.
- Liquidity: Mutual funds can be sold at any time. The price is determined by the net asset value, or NAV, which is the value of all of the holdings divided by the number of shares, less any redemption fees. Some mutual funds, known as exchange-traded funds, trade like stocks, based on supply and demand.
Cons of Mutual Funds
Mutual funds also have a few disadvantages, including the following:
- Fees and taxes: All mutual funds have fees that must be paid by investors. In addition, mutual funds have capital gains, or profits, that are distributed to shareholders, either in cash or through additional shares. These gains are taxable. Plus, you might have taxable gains in a mutual fund even if you don’t sell the fund.
- Moderate gains: Diversification is usually considered an advantage with mutual funds, but in some cases, it could be considered a disadvantage. Because mutual funds spread your money among different investments with an eye toward avoiding any large losses, the strategy also avoids large gains.
- Risk of loss: Mutual funds tend to be a safer investment than individual stocks, but you can still lose money. If the value of the investments held in a mutual fund declines, the value of the fund will also decline. If you then sell your shares at a lower price than the price you bought them for, you will lose money.
Pros of Stocks
Investing in stocks has certain advantages. Here are three of the most important ones:
- Upside potential: Investors fortunate enough to buy stock in “the next big thing” could reap a handsome profit if they hold on to the investment for long enough. Look no further than Tesla. Investors who bought the stock at the beginning of 2020 would have paid about $130 a share. If they held on to it for the next year and a half, they would have seen their investment rise more than 360% to about $605 a share in June 2021.
- Dividends: Some companies distribute earnings to stockholders in a quarterly or annual dividend.
- Voting rights: When a publicly held company makes certain decisions, the owners of a majority of the shares must support the decision or it cannot be implemented.
Cons of Stocks
Just like with any investment, stocks also have potential drawbacks. Here are two of the biggest:
- Risk: When you buy stock in a company, you tie your investment to the fortunes of that company. If those fortunes collapse, so does the stock price. In cases when a company you’ve invested in goes bankrupt and closes its doors, your stock is basically worthless.
- Volatility: Stocks can fluctuate wildly in price based on a number of factors that are hard to foresee, ranging from political and market events to something completely out of the blue, like the COVID-19 pandemic. Because a single stock can’t offset risks through diversification like a mutual fund, investing in stocks is a much more bumpy ride.
Why Not Invest In Both Mutual Funds and Stocks?
Mutual funds and stocks both have pros and cons, so it’s important to assess which are most important to you before deciding on an investment vehicle. If you are very risk-averse, mutual funds might help you sleep better at night because they are better able to weather extreme market ups and downs. If you are willing to trade volatility for a much bigger potential long-term gain, then stocks might be the way to go.
Takeaway
On the other hand, there’s no reason you can’t invest in both stocks and mutual funds. In fact, a well-diversified portfolio will include both – as well as bonds, real estate and other investments. Investing consistently over time, monitoring your investments and taking the appropriate amount of risk will help you to be a successful investor, regardless of whether you put your money in mutual funds, stocks or both.
Vance Cariaga contributed to the reporting for this article.
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- Ramsey Solutions. 2021. "Should You Buy Stocks? Here’s What You Need to Know."
- Investor.gov. "What is Risk?"
