Stocks vs. Mutual Funds: How They Differ for Your Investing Strategy
If you’re starting to learn to invest, you may understand the basics of the vast number of investment options you have.
You’ve likely heard of the major categories of stocks, bonds, mutual funds, index funds, exchange-traded funds (ETFs), and other options.
Your preliminary research may have defined these categories.
It may have contrasted different investment types, such as stocks and bonds.
You may have learned about the differences between mutual funds and ETFs, too.
This is all crucial information to understand before you build an investment strategy.
To help you understand two major categories of investments on a deeper level, we’ll dive into the differences of stocks vs. mutual funds below.
Here’s what you should know.
What Are Stocks?
Stocks represent a piece of ownership of a company.
Owning stock may allow you to vote on initiatives the company puts before its shareholders.
It may also entitle you to dividend payments the company decides to declare and pay to its shareholders.
Most commonly, people view stocks as a way to invest in these publicly traded companies.
If the company performs well, a person will usually benefit financially.
This may be in the form of dividend payments or an increased stock price.
Stocks are traded on stock exchanges. You can use these exchanges to buy or sell the shares of stock you own.
Not all stocks are publicly traded, though. Some small companies have privately held stock.
This stock may be restricted and you may not be able to trade it as you wish. It may not have a market value that is updated daily, either.
Benefits of Investing in Stocks
Investing in individual stocks has some positive factors to consider.
You have control
When you invest in individual stocks, you get to pick and choose every single investment you own.
You get to decide precisely when you want to buy or sell each investment.
You may decide to hold one investment for decades and another for a few weeks.
As a stock investor, you can choose to hold stock in 30 companies or three.
It’s up to you to decide what percentage of your portfolio each stock makes up, as well.
Some people may decide to hold a large percentage of their portfolio in a stock they believe has a bright future.
The key is no one else is making those decisions for you.
No expense ratio fees
When you invest in mutual funds or exchange-traded funds, someone must manage these funds.
That management comes with costs.
As a result, you have to pay management fees in the form of an expense ratio.
These expense ratios reduce the returns of mutual funds and ETFs.
Stocks do not have expense ratios. Instead, you manage your stock holdings yourself.
While this does take time and effort, you don’t charge yourself for that time.
This means you get to keep all of the returns for yourself.
No commission trading options
In the past, you usually had to pay commission fees to trade stocks. This could add up if you traded often.
Thankfully, pioneers in the industry created no commission trading options.
They became so popular that big brokerage firms had to adopt this practice themselves.
Today, many brokerage firms allow you to trade stocks without paying commissions.
This lowers the costs of trading stocks even more compared to the past.
Can trade throughout the day
Stocks can be traded during the trading hours of the exchange they’re listed on.
You may even be able to trade after hours, depending on your brokerage.
This is much more flexible than mutual funds, which only price and trade once per day.
Drawbacks of Investing in Stocks
Of course, downsides also exist.
Risk of loss
As with any investment, investing in stocks is inherently risky. Whenever you invest, you have a risk of loss.
This is even more pronounced when investing in individual stocks.
The company you choose to invest in could go bankrupt. If this happens, their stock could become worthless.
You could lose every penny you invested if you hold the stock until it hits zero.
Must research investments yourself
Figuring out which stocks to invest in is entirely up to you.
To find suitable investments, you often have to perform a lot of research.
This can be highly complex and time-consuming.
You then have to continue researching stocks as you own them.
This way, you know whether to buy more or when to sell them.
May not properly diversify
When investing in individual stocks, prices change daily.
Without close monitoring, it’s easy for a diversified stock portfolio to become less diversified than intended.
As you buy and sell new positions, you may end up with large concentrations in specific sectors of stocks, too.
What Are Mutual Funds?
Mutual funds are a way multiple people can pool their money together to invest in various investments based on their common goals.
In practice, people don’t come together and form a mutual fund themselves.
Instead, investment companies create mutual funds which investors then decide to invest in.
A mutual fund may decide to invest to mimic an index, such as the S&P 500. These mutual funds are called index funds.
Other mutual funds may decide to invest in a specific sector, such as banking stocks.
Mutual funds can invest in other investments, too. Bond mutual funds and several other types also exist.
Some mutual funds try to beat the market and earn outsized gains by buying and selling stocks.
These are called actively managed mutual funds.
No matter what type of mutual fund you invest in, they’re professionally managed by a fund manager and their staff.
These managers and the costs to run the funds add up, though.
You end up paying these through a fee called an expense ratio. This reduces your returns.
Pros of Using Mutual Funds to Invest
Using mutual funds to invest has upsides.
Fund managers and their staff professionally manage mutual funds.
These investment experts can attempt to help guide a mutual fund to meet its investment goals on your behalf.
Index funds are managed to copy the returns of the index they are mimicking.
This doesn’t require as much work but is still more than the average person could do independently.
Actively managed funds are often managed in an attempt to beat the market.
While this doesn’t always happen, the management professionals likely have more experience than you would have trying to do it yourself.
Mutual funds invest in several underlying investments.
This may result in reduced risk because all of your investments aren’t in a single stock.
Some mutual funds are more diversified than others.
S&P 500 index funds are diversified across 500 companies.
That said, a mutual fund focused on the banking sector may only be invested in a few banks.
If the banking sector declines as a whole, your banking mutual fund would likely fall in value, as well.
It’s important to understand that diversified portfolios and mutual funds can still face losses.
Diversification for the sake of diversification can lead to undesirable outcomes. When a bunch of mutual funds all hold basically the same stocks, then selecting multiple funds in the name of diversification doesn't yield the risk protection that individuals might assume. To get protection, you need to find funds that have different holdings or strategies.
Diversification for the sake of diversification can lead to undesirable outcomes.
When a bunch of mutual funds all hold basically the same stocks, then selecting multiple funds in the name of diversification doesn't yield the risk protection that individuals might assume.
To get protection, you need to find funds that have different holdings or strategies.
May require less time and attention
When you own a mutual fund, you must still research it and decide if it is a good fit.
You have to continue monitoring it to know when to sell, too.
However, you don’t have to do as deep of a dive on a mutual fund as you likely would for a stock.
The professional management and diversification mutual funds offer may help you feel comfortable monitoring them less than individual stocks that may go bankrupt.
Cons of Using Mutual Funds to Invest
Mutual funds aren’t perfect, though.
Expense ratios and fees
Investing in a mutual fund isn’t free.
Some funds charge load fees to buy or sell a mutual fund, although these are increasingly rare.
Even so, almost every fund charges expense ratios and management fees.
This expense ratio reduces your returns compared to owning the assets in the mutual fund yourself.
This can have a considerable impact over the long term.
Over 20 years, a 0.5% expense ratio could add up to a hefty reduction in the total dollar value of your portfolio.
As Dr. Mauck points out, "even relatively small differences in fees in absolute terms, say 1%, really add up over long periods of time due to compounding.
The fees for passively managed funds may be lower, but they likely still exist.
Dr. Mauck recommends choosing funds purposefully to avoid unnecessary fees. He says that unfortunately, "individual investors tend to spread their money amongst several S&P 500 funds rather than picking the one fund with the lowest fee."
Don’t have complete control
When you invest in mutual funds, you get to choose which funds you invest in.
You don’t have complete control, though.
Let’s say you buy a technology-focused mutual fund. After holding the fund for a year, you decide you no longer want to have any investment exposure to Alphabet.
You can’t tell the mutual fund to sell Alphabet. Instead, you’d have to sell the fund and buy another that didn’t invest in Alphabet.
Returns may not meet your expectations
Mutual funds don’t guarantee particular returns.
They may share their historical performance, but it is not a guarantee of future returns.
Even index funds don’t often match the returns of the indexes they follow.
This is due to the expense ratios you must pay to invest in the fund that the index does not have.
Only trades once per day
You can buy stocks any time markets are open. Unfortunately, mutual funds only price and trade once per day.
You can’t view real-time prices and make live trades with mutual funds during market hours if a sharp swing in the market occurs.
Instead, your trade gets priced at the end of the day which could result in a more significant loss than if you could have sold mid-day during a downturn.
Build a Portfolio Based on Your Needs
Ultimately, you must build a portfolio that helps you reach your goals while meeting your risk tolerance.
This very likely could include owning both stocks and mutual funds.
When you invest in stocks and mutual funds, make sure you consider the makeup of your entire portfolio.
A mutual fund holds positions in several companies. If you own two similar mutual funds, you may have too much exposure to a particular company.
This could be amplified further if you own individual stock in the company, too.
The benefit of choosing both types of investments is you get the best of both worlds.
You could invest in a mutual fund focused on bonds and pick individual stocks at the same time.
You can also create any other combination that works for you.
Consult an Expert
If you need help choosing an investment or building a portfolio, you may want to consult an expert.
A financial advisor may be able to help individual investors. It’s essential to understand how they make money, though.
Some advisors work on commission. This compensation may impact the advice you receive.
To make sure you receive advice in your best interests, consult a fee-only fiduciary financial advisor.
These advisors cannot accept commissions from products and services. They must also give you advice in your best interests.