If you’re getting started in investing, you might be wondering whether you should invest in mutual funds or stocks. Mutual funds often seem safer, but stocks have the potential for big returns. What’s the difference between mutual funds and stocks, anyway? Here’s what you need to know about the advantages and disadvantages of each.
This guide to deciding between mutual funds and stocks will cover:
- Mutual Funds vs. Stocks
- Mutual Funds: Pros
- Mutual Funds: Cons
- Stocks: Pros
- Stocks: Cons
- Why Not Invest In Both Mutual Funds and Stocks?
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 stock in the stock market, you are buying a little bit of the company, and you are now a part owner, or shareholder, of the company. Stocks are sometimes referred to as equities.
|At a Glance: Mutual Funds vs. Stocks|
|What It Is||A piece (share) of an individual company; shareholders can vote on company issues. Shares increase in value due to supply and demand and might pay dividends.||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 to know about the companies they’re investing in; those who can buy and hold their investments, buying and selling at the right time||Those who want someone else to make their investment decisions: 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 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||Learn About Types of Mutual Funds|
See the Best Mutual Funds of 2019
Investing in a mutual fund has some advantages over investing in individual stocks. Here are three 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, the price of stock often rises 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 it is to choose the best stocks, bonds and other investments to purchase for their funds. These experts research investments to select the best ones and then monitor the performance of those investments. Some mutual funds, called index funds, do not have professional managers but track the investments in an index, such as Standard & Poor’s 500 index.
- 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. There are some mutual funds, known as exchange-traded funds, or ETFs, which trade like stocks, based on supply and demand.
What You Need to Know Before Investing: Mutual Fund Fees
Some disadvantages to mutual funds exist, as well. Some of these include:
- Fees and taxes: All mutual funds have fees that must be paid by investors. In addition, mutual funds have capital gains, or profits, which are distributed to shareholders, either in cash or by purchasing additional shares. These gains are taxable. Plus, you might have taxable gains in a mutual fund even if you don’t sell the fund. “These investments are traded by the manager within the scope of the prospectus and can create taxable capital gains even if you do not sell the mutual fund,” said Greg Klingler, CFP Director, GEBA Wealth Management.
- Moderate gains: Diversification is an advantage of mutual funds, but in rare cases, it could be considered a disadvantage. Because mutual funds spread out your money among different investments with an eye toward avoiding any large losses, the strategy also avoids large gains.
- Risk of loss: Mutual funds are generally considered 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.
Also Check Out: ETFs vs. Mutual Funds
Investing in stocks has some advantages. Here are four 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 onto the investment for long enough.
- Dividends: Some companies distribute earnings to stockholders in a quarterly or annual dividend. Stockholders can get a check every year or every quarter, and they still have the stock, which might also appreciate in price.
- 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.
- Tax advantages: “While you hold stock, you will not be taxed on capital gains,” explained Klingler. “Capital gains are taxed at a lower rate than ordinary income if you have held the stock for more than a year. Stocks that are held at death receive an automated step up to the value at death, which means that your heirs will not have to pay taxes on the capital gains which were accrued during your lifetime. Dividends are generally taxed at ordinary income tax rates.”
You’ll find some disadvantages to investing in stocks as opposed to mutual funds. Three important drawbacks are:
- Risk: When you buy stock in a company, you tie your investment to the fortunes of that company. On the upside, you might find the next Apple or Amazon. On the downside, you might find the next Enron.
- Volatility: Company stocks can fluctuate in price. Large company stocks, for example, have lost money in one out of every three years, on average, according to Investor.gov. The price of a given stock can be affected if the company produces a faulty product, if a competitor cuts its price or if there is a political or market event that negatively affects the company.
- Fees: Some brokerages charge as much as $50 if a broker helps you buy or sell stocks. Online brokers often charge $7 or less per trade if you do it yourself.
Mutual funds and stocks both have advantages and drawbacks, so what you invest in should be based on the pros and cons that are more important to you. If you are very risk-averse, mutual funds might help you sleep better at night. If it’s important to you to own part of a company you admire, buying its stock might be the way to go.
There’s no reason you cannot invest in both stocks and mutual funds. In fact, a well-diversified portfolio will include both, as well as 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 a bit of both.
Keep Reading: How To Buy Stocks Online or With a Broker in 4 Steps
Karen Doyle is a personal finance writer and a former financial advisor.
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