Which assets are best to add to a portfolio depends on the individual situation. First of all, on the financial goal and risk tolerance. There are two ways to make money on the growth of the stock market. These are investing in individual companies and using collective investment instruments.
The following comparison of mutual funds vs stocks will provide everyone with a final decision on which of these asset classes is preferable.
Table of Contents
Key Difference
The key comparison points of mutual funds vs stocks are summarized in the table.
| Parameter | Stock purchase | Investments in the fund |
| Ownership rights | Share in the company | Share in net assets of the fund |
| Portfolio management | On their own | Through a manager |
| Investment risk | High | Moderate due to high diversification |
| What affects the cost | Supply and demand ratio on the stock exchange | Net asset valuation |
| Frequency of price change | Continuously throughout the day (with each new transaction) | Once a day |
| Liquidity | Depends on investors’ interest in the company | For an open-end mutual fund, always high (stocks can be sold to the management company) |
| Expenses | Payment for brokerage services | Commissions on the purchase and sale of a fund’s stock, as well as ongoing fees for management, which reduce the final return |
Pros & Cons of Mutual Funds
The advantages and disadvantages of mutual funds are summarized in the table below.
| Advantages | Disadvantages |
| Rapid diversification | Profit is lower than expected |
| Reduction of portfolio risks | High costs |
| Professional management | Fiscal inefficiency |
| Receiving passive income or automatic reinvestment | Lack of opportunity to earn on intraday trades |
| Simplicity (no need to have in-depth knowledge of the stock market) | There is no precise information on net assets |
Pros
Mutual funds have advantages that make them a great investment for beginners.
Instant diversification
A mutual fund invests the pooled investments of its participants in many securities. For example, an index fund that replicates the S&P 500 owns stocks of 500 companies. By choosing to invest in it, a person indirectly receives a stake in each.
Mixed funds and target-date funds handle multiple asset classes at once. A portfolio that includes a single mutual fund of this type would already be well diversified.
Minimizing the risks of investing
The main risk of investing is the loss of the capital invested due to a decline in quotations. It is unlikely that all companies that are listed in the net assets will experience difficulties or go bankrupt at the same time. This means that the stock price of a mutual fund is less volatile than that of an individual company.
However, this does not indicate it is safe to buy this asset class. You should choose funds that have an investment strategy that matches your risk tolerance level.
Professional asset management
People who want to earn above-market returns can choose actively managed mutual funds. They are managed by experienced investors who select the most promising securities. A professional fund manager operates within a specific strategy.
Passive income
Nearly all mutual funds pay dividends and distribute capital gains. A person can both live on this passive income or reinvest it by increasing their stock holdings.
Frequently, a mutual fund offers to set up automatic dividend reinvestment. It is convenient and helpful for people with poor financial discipline.
Simplicity
Choosing individual stocks for your investment portfolio requires quite a bit of knowledge. There are far fewer factors to consider when selecting a mutual fund.
Cons
Collective investments have their disadvantages. First of all, they are significant for experienced investors. However, beginners should also be aware of them.
Profit is lower than expected
By no means every fund manager can generate returns higher than the broad market index shows. Past performance cannot be a guarantee of future returns. Passive mutual funds are believed to outperform most actively managed funds by decades.
High expenses
Any mutual fund retains a management fee, which is expressed as a percentage of its net assets. It is deducted evenly from their value over the course of the year, thereby reducing the fair value of the fund’s stock.
The amount of the fee depends on the investment strategy. Index funds on U.S. stocks or bonds have minimal fees – fractions of a cent. But it can be as high as 1 per cent or higher when the net assets are:
- foreign securities;
- derivatives;
- precious metals, etc.
In addition to management fees, extra commissions may be deducted on the purchase and sale of stocks.
Fiscal inefficiency
Many mutual funds pay dividends and distribute capital gains. The tax rate on such income depends, in part, on how long the fund itself has held the securities from which it has paid its participants.
Investing in actively managed funds can result in much higher tax liabilities than investing in individual stocks or index funds.
When this is the only significant drawback for an investor, a mutual fund can be replaced with ETFs. They don’t distribute capital gains, owning their stocks has fewer tax consequences.
Lack of opportunity to earn on intraday trades
The mutual fund stock price is updated once a day. Therefore, such assets are not proper for intraday trading.
There is no precise information on net assets
A mutual fund may update information about the securities that make up its net assets once a quarter. When it comes to an index fund, this is not a problem, as the composition of the indices does not change more often.
But in the case of an actively managed fund, investors in fact have no idea as to where their money is invested. In such a situation, a person cannot be sure that their portfolio is properly diversified. Particularly when investing in several mutual funds with similar strategies.
Pros & Cons of Stocks
Investing in individual stocks also has its advantages and disadvantages.
| Advantages | Disadvantages |
| Potentially higher profitability | Poor portfolio diversification |
| Full control over assets | More risks |
| No management fees | Time costs |
| Taxation efficiency |
Pros
Investing in individual stocks has 3 significant advantages over equity mutual funds. But to be able to take advantage of them, you need to have a good understanding on how the stock market works.
Potentially higher profitability
There are companies that perform better than the broad market. For example, quotes of PBF Energy Inc (PBF) have risen 89% over the past 12 months. The fund’s securities, which replicate the S&P 500, have risen just 13.6% over that time.
When an investor puts together a portfolio of such stocks, they will make a much higher return than investing in an index mutual fund. Individual stocks are often chosen by people who are not inclined to a passive buy-and-hold strategy. They are used by those who hope to make money from fluctuating stock prices. How much more profitable this turns out to be than investing in actively managed stock mutual funds depends solely on the individual.
Full control over assets
An investor knows exactly which companies their money is invested in at any given time.
No management fees
Expenses when investing in stocks of individual companies are only brokerage fees. It is possible to find favorable rates in the USA, with 0 commission for stock transactions.
Tax efficiency
In a buy-and-hold investment strategy, gains are not locked in and almost all dividends (except REITs and MLPs) are taxed at a reduced rate.
Eventually, even when a person sells stocks, they can control capital gains and offset them by locking in losses. When investing in a mutual fund, however, one will only know at the end of the year exactly how much tax one will have to pay.
Cons
There are disadvantages to investing in individual stocks. The more significant they are, the less experience and knowledge a person has.
Poor portfolio diversification
The price of a stock can reach tens and hundreds of thousands of dollars. A large amount of capital is needed to copy the main stock exchange indices themselves. When an investor chooses only 5-10 companies, the influence of each issuer on the total value of the portfolio will be too strong.
High risks
High risk of capital loss is the result of poor diversification. In times of crisis, such a portfolio may be more volatile than the broad market.
Risks increase when an investor chooses stocks for high potential returns. For example, the previously mentioned PBF Energy Inc (PBF) has a beta coefficient of 1.94. This means that this company’s stock is almost twice as volatile as the broad market.
Time costs
It takes a lot of time to analyze the leading companies in an industry and choose the best one for your portfolio. And to improve diversification, you need to cover almost all sectors of the economy.
Why is it so important to avoid buying single stocks and invest in mutual funds instead?
When comparing mutual funds vs stocks, financial advisors recommend that beginners use collective investment instruments and avoid investing in individual stocks. Buying the latter is a great way to make money, but only for those who understand how to do so.
Individual Stock Investing
Investing in individual stocks is the compilation of a portfolio of stocks of several companies, for example Apple, Coca-Cola, etc. When purchasing securities, a person becomes a co-owner of a business. He can receive a part of profit in the form of dividends and take part in the management of the company – vote at the shareholders’ meeting.
But for most people, the purpose of buying individual stocks is to make money on the rapid growth of quotations or to receive a high dividend yield.
Unlike mutual funds, individual company stocks are proper for investors who:
- have sufficient knowledge of economics, fundamental analysis, etc..;
- are willing to spend time to select a company that will perform better than the broad market;
- have sufficient capital to diversify their investments in individual stocks;
- have a high risk tolerance.
Otherwise, collective investment through exchange traded funds or management companies is preferable.
Benefits of mutual funds
Changes in the value of a fund’s stocks are in direct proportion to fluctuations in the quotations of the securities owned by the fund. Therefore, by purchasing such assets, a person actually benefits from owning a diversified portfolio.
However, the investor does not become a co-owner of the companies that are included in the net assets of the fund. They can not vote at shareholders’ meetings and influence decision-making.
This investment instrument is highly recommended for beginners for the following reasons:
- Low entry thresholds. There are still mutual funds that set initial investments at $3,000 or more and hold initial and final investments. But leading management companies have already abandoned this practice.
- The ability to fully hand over money management to a professional.
- Minimal time spent on reinvestment and portfolio rebalancing.
The main objectives of investing in diversified stock funds are to save time in selecting individual stocks, reduce risk and generate passive income. Bond funds offer the same benefits. This is why many investors favor them over buying individual debt securities.
For an investor who seeks results much higher than the market average, it is more appropriate to use individual stocks.
Bottom Line
For a person who is just getting acquainted with the stock market, investing in mutual funds and exchange-traded funds is the best decision. Many people use only these financial instruments and achieve their desired investment objectives.
But investing in a mutual fund is not proper for everyone. When a person is interested in studying the market and finding the best companies, BeatMarket service will assist. The stock screener allows you to choose securities according to many parameters, including dividend history. And the BeatMarket Scoring system is indispensable when searching for undervalued companies.
FAQ
Why do people invest in mutual funds instead of stocks?
Investors prefer passive mutual funds because they provide instant portfolio diversification even for people with little capital. Actively managed funds are chosen because they offer a chance to get returns above the market average.
Is it better to invest in single stocks or mutual funds?
A beginning investor is better off investing in a mutual fund or ETF. This makes diversification easier. In addition, there is a high probability that the returns will be much higher than if you try to beat the market on your own.
What is the biggest difference between stocks and mutual funds?
The key point in comparing mutual funds vs individual stocks is that by buying an individual stock, a person is investing in only one company. When buying mutual fund shares, they indirectly invest in a large number of companies at once.
Are mutual funds safer than stocks?
Yes. Mutual fund assets are generally well diversified. This makes its stock price volatility lower than most stocks owned.
