The best investors take their investments seriously. When you know the strengths and weaknesses of mutual funds vs stocks, you lay the groundwork for investment success.
What Is the Difference between Mutual Funds vs Stocks?
Mutual funds are often the first investments a person is exposed to. When you are offered a 401(k) through work, you usually choose from an array of mutual funds. However, most of what we hear about on the news has to do with stocks. There are differences, but how they overlap can confuse new investors.
What Are Stocks?
Corporations turn to the stock market to find investors and raise capital to put towards the costs of doing business. Stocks are the publicly traded ‘shares’ in a corporation that raises this capital. When someone owns stock in a corporation—for instance, in Apple or Microsoft—they become a ‘shareholder.’
Shareholders help decide how the corporation will operate through voting at shareholder meetings. The more shares a person owns, the more voting power they have in that corporation. They often receive dividends—the proportional share of the corporation’s profits.
As the corporation grows and prospers, the value of the shareholder’s stocks also grows. Shareholders can sell their shares when they choose, but the value of their shares or stocks will depend on the overall value of the corporation and the number of shares on the market. Some corporations offer Employee Stock Options to their employees as a part of their benefits package.
Even though a corporation may be considered highly valuable at the start of the day, the perceived value will drop if far more shares are up for sale than usual. You might hear market analysts and journalists refer to this as a decrease in ‘investor confidence.’ It’s often tied to bad news about the corporation and fears about the future of the company. When investor confidence in a corporation drops, or when the market is flooded with many stocks, investors will see the value of those affected stocks drop.
However, over time, most stocks have spikes and drops in their value. Most established stocks see an upward trend and most investors in popular stocks can rely on their investments to grow over the years.
What Are the Different Categories of Stocks?
When new investors look into mutual funds vs stocks, they usually start by classifying the stocks by size and style. When looking at size, the stocks are usually:
- Large-cap – Large capital corporations with stable stock prices
- Mid-cap – Medium capital corporations with relatively stable stock prices
- Small-cap – Smaller capital corporations with fairly unstable stock prices
When looking at the stock’s style, there are two categories: growth and value. Growth stocks grow faster and more strongly. The downside is that when these stocks suffer setbacks, the prices often drop significantly. In contrast, value stocks grow slowly and steadily. The price fluctuations experienced by value stocks are not as dramatic as with growth stocks.
What Are Mutual Funds?
Many beginning investors hear references to stocks and mutual funds that seem to be used interchangeably. There is overlap, but mutual funds are not quite the same as stocks. It’s important to understand these differences when you evaluate mutual funds vs stocks and which is best for you.
The best way to think of a mutual fund is as a type of vehicle. You pay an expert to load the vehicle and guide you toward your goal. They can load different investments into it, but every investment should help reach the overarching goal.
Most mutual funds contain stocks and/or bonds. They can also contain certificates of deposit, treasury bills, and real estate investment trusts. The fund might be intended as a safer fund with low rewards (money market funds) or a higher-risk fund with the potential for greater rewards (small-cap funds). It might be tied to a specific retirement year with a corresponding change in risk/reward as the retirement year approaches.
The fund manager keeps the goal of the fund in mind as he sells and purchases stocks and bonds as part of the mutual fund. A good fund manager monitors the performance of all the investments within a mutual fund to make sure they are growing at acceptable rates. A bad fund manager might not pay close attention and keep a devalued investment as a part of the fund, lowering its value.
Because the fund is goal oriented, the expert fund manager can manage the fund for large groups of people pooling their money together. This keeps costs low, both for conducting transactions and employing the fund manager.
What Are the Different Types of Mutual Funds?
Investors will want to understand the variety of mutual funds available when comparing mutual funds vs stocks. Mutual funds can either be qualified or unqualified. Qualified simply means the money is considered retirement money offered by your employer. This qualifies it for certain tax advantages. SIMPLE and SEP IRAs, 401(k)s, and 403(b)s are qualified retirement plans that typically use mutual funds.
If your employer doesn’t offer any qualified mutual funds, you can still invest in an IRA on your own. Many investors also invest in mutual funds for purposes other than retirement.
The most common categories of mutual funds are:
- Money market funds – Stable (think safer) funds with low growth, often closely tied to the value of cash
- Fixed income funds – Fairly stable funds with bond investments that pay a specific amount out to investors
- Equity funds – Less stable funds with stock investments that seek more growth and carry greater risks of losses
- Balanced funds – Funds that mix stocks and bonds to provide both growth and stability
- Index funds – Funds that aim to match the performance of one of the stock market indexes, such as S&P 500
- Specialty funds – Funds that specialize in a certain type of stock, such as commodities, real estate, or socially responsible corporations
What Are Exchange-Traded Funds?
You might also come across something called an exchange-traded fund (ETF). ETFs are separate from mutual funds, though they share some similarities. Both mutual funds and exchange-traded funds pool the finances of groups of people to keep costs low. However, most ETFs are passively managed and linked closely to an index. Mutual funds can only be bought and sold once each day, while exchange-traded funds can be bought and sold multiple times throughout the day.
Do Mutual Funds Carry Less Risk than Stocks?
When you compare mutual funds vs stocks, mutual funds don’t automatically mean less risk. There are both higher-risk and lower-risk stocks just as there are higher-risk and lower-risk mutual funds.
However, if you are comparing the same category of mutual funds vs stocks, such as mid-cap equity mutual funds vs mid-cap stocks, mutual funds are the safer bet. Why? Mutual funds are diversified and actively managed.
A mutual fund splits your invested money between a dozen or so corporations. If any of them do poorly, the other investments can often compensate. With stocks, you might have all your money invested between two or three companies. If one of the companies does poorly, you feel that loss much more.
A dedicated investor who enjoys watching the stock market regularly and investigating potential corporations could be successful in managing her or his own stock portfolio. The knowledgeable investor might do just as well or better than the average mutual fund manager at minimizing risk. The trade-off is that the dedicated investor needs to do all the research and groundwork on their own, usually as a hobby.
But for the average investor, a mutual fund means less risk in practice. The fund’s investments are both diversified and professionally managed by a financial expert. Most investors don’t have the time and expertise to diversify their stock portfolio enough to minimize risk.
How to Choose Mutual Funds vs Stocks
The best way to determine which is best for you when comparing mutual funds vs stocks is to answer a few questions to determine what your investment goals are and how well you can meet them on your own.
Mutual Funds vs Stocks: How Much Do I Know about Investing and What Am I Willing to Learn?
If you have little to moderate knowledge for evaluating stocks and bonds, you will probably want to start with a mutual fund. If you are willing to learn more about investing, you can use your quarterly mutual fund statements to understand how experts diversify and manage the stocks in the fund. If you know a lot about stocks, you might want to focus instead on a diversified stock portfolio.
But investing in mutual funds remains a solid investment strategy for all experience levels. Most knowledgeable investors keep mutual funds as an integral part of their larger investment portfolio.
How Much Time Do I Have to Dedicate to Investing?
When you invest in stocks, you will need to set time aside to research and later monitor the corporation’s performance and business practices. You will need to spend time each week staying up to date on the wider economy. If investing is a hobby you are passionate about, this level of commitment won’t feel like a chore.
Yet, for most investors, it’s easier to pay an expert to manage their investments through a mutual fund. Wealthy investors can hire a full-service broker to manage their stock investments personally, but even this requires a time commitment. Full-service brokers must meet with their clients quarterly to go over how their investments are performing.
How Much Money Do I Have Available?
Regardless of how you invest between mutual funds vs stocks, you must have money set aside. Many mutual funds set their minimums near $1000. If you open a mutual fund account through an automatic debit, that minimum can be as low as $50 or $100 a month.
Most robo-brokers have minimums ranging anywhere from $50 to $500 to start buying stocks. Those with better research features—a necessity when you’re investing in stocks—have higher minimums.
Mutual Funds vs Stocks: What Will I Use These Funds for and When?
You need to have a goal in mind for your funds. Maybe you’re thinking about investing in stocks as part of your retirement strategy for twenty years down the road. Or maybe you want to open a mutual fund to earn more money for annual vacations. Or maybe you’ve just had children and you want to open investments as a gift for when they grow up.
The timing of your goal and the importance of earning larger gains (or minimizing losses) will help you determine how to invest. Goals farther out can tolerate much more risk. Goals that are one to five years out have far less risk tolerance.
Someone who won’t use their retirement funds for 20 years might have more small-cap holdings in their portfolio than the person planning to retire in two years. Someone with disposable income looking to invest as a hobby can afford far more risk than the person who will need those funds to pay for college.
A mutual fund or a diversified stock portfolio can help investors meet any of these goals. But the goal and its end date should determine what kind of diversity the investor needs built into his portfolio.
Stocks and mutual funds offer a lucrative way for investors to plan for future goals. Stocks have the potential to earn greater rewards, but there is a steep learning and dedication curve to achieve success. Mutual funds are the best bet for most investors, offering both diversity and expertise built right in.