Mutual funds and stocks represent two of the most popular securities for investors. But is it better to invest in a basket of stocks via mutual funds or buy individual stocks directly? This guide examines the pros and cons of mutual funds versus stocks to help investors decide which makes the optimal investment.
Key differences between mutual funds and individual stocks include diversification, costs, risk profile, return potential, trading flexibility, access to professional management, ease of investment, and tax efficiency. There is no definitively “better” option as each vehicle has advantages that may appeal to different investor objectives and preferences.
Below we compare mutual funds and stocks across a range of factors for investors to consider when constructing their portfolio:
Mutual funds provide instant diversification across dozens or hundreds of individual stocks or bonds. Investing in just one mutual fund achieves broad exposure to a market sector or index. Even concentrated sector funds are more diversified than buying a handful of stocks directly.
Owning individual stocks offers little inherent diversification. Investors need to purchase multiple stocks across sectors and industries to achieve adequate diversification, requiring significantly more capital.
Verdict: Mutual funds easily win on diversification benefits for smaller investors. Their diversified structure helps mitigate uncompensated risks.
Costs and Fees
Actively managed mutual funds carry recurring expense ratios, typically 1% or more annually for stock funds. Even index funds have expense ratios around 0.10% or higher. There may also be transaction fees, loads, and broker commissions.
Buying individual stocks as a do-it-yourself investor involves trading commissions per transaction. But once purchased, the shares themselves have no recurring fees or expenses like mutual funds.
Verdict: For buy-and-hold investors making few trades, stocks carry lower costs thanks to no recurring fees. But frequent traders face higher transaction costs in stocks.
Owning shares in a mutual fund provides exposure to the blended risk profile of the fund’s holdings. The diversified nature helps mitigate overall portfolio risk and volatility relative to individual stocks.
Individual stocks face full company-specific risks based on fundamentals, industry trends, macro events, earnings surprises and other idiosyncratic risks. Lack of diversification amplifies volatility.
Verdict: Mutual funds’ diversification smoothes out risk and volatility over time. Concentrated stock bets carry greater downside risk.
The average mutual fund fails to match broad market index returns after fees over time, although a small minority of skilled managers do beat their benchmarks. The diversified structure mutes huge gains but also protects against severe losses.
Individual stocks offer nearly unlimited return potential if selected wisely. Owning a stock directly exposes an investor to the full upside. However, the mirror-image downside potential is also greater with undiversified investments.
Verdict: Good stock pickers have higher return potential buying individual stocks but also greater risk. The average mutual fund lags markets but with smoother returns.
Trading Flexibility and Control
Investors own shares in a pooled mutual fund with little direct control over buy/sell decisions, which are made by the fund manager. Investors can generally only add to or redeem fund shares on a daily basis rather than trade intraday.
Owning individual stocks offers complete trading control and flexibility. Investors decide when and what stocks to buy and sell at any time during market hours. Stocks offer greater trading autonomy.
Verdict: For tactical traders, individual stocks provide more granular trading control versus pooled investment vehicles like mutual funds. But most mutual funds offer daily liquidity for redemptions.
Mutual funds provide investors exposure to the collective expertise of professional fund managers responsible for research, analysis and trading decisions. This can benefit less experienced investors.
Buying individual stocks means the investor is fully responsible for conducting analysis and making all buy/sell decisions. Less skilled investors may struggle picking winners and managing a portfolio through various market conditions.
Verdict: Mutual funds allow tapping the experience of market professionals. However, fund manager skill still varies greatly.
Ease of Investment
Investing in mutual funds only requires selecting and buying shares of a particular fund in the amount desired. The fund manager handles underlying security selection and trading. Ongoing administration is simple.
Successfully investing in individual stocks requires significant research into each company, monitoring fundamentals, valuation analysis, assessing technical charts, and ongoing evaluation of holdings. It involves more complex analysis.
Verdict: Mutual funds offer a much simpler process for investors to participate in markets. Individual stocks demand greater research skills and active oversight of positions.
Because mutual funds frequently trade positions and realize capital gains, funds often generate taxable capital gain distributions passed through to shareholders annually. Actively managed funds tend to be less tax efficient.
For buy-and-hold stock investing, taxes can be deferred until shares are sold. Investors control when gains are realized to strategically optimize tax liability. Passive stock investing provides greater tax efficiency.
Verdict: For taxable accounts, individual stocks offer more control over realizing gains. Mutual funds often create annual tax drag from capital gain distributions.
Owning mutual funds may distance some investors psychologically from market volatility since they do not own shares of individual companies directly. This helps overcome fear and anxiety when stocks decline.
Watching individual stock positions fluctuate daily triggers stronger emotional reactions to volatility for some investors. There is greater attachment to specific company names owned versus a faceless mutual fund.
Verdict: Mutual funds may promote a slightly more detached perspective during market swings. But investor psychology varies greatly.
Key Differences Between Mutual Funds and Stocks
- Professionally managed
- Diversification across many securities
- Lower volatility but capped upside potential
- Higher costs like expense ratios
- Less trading flexibility
- Simpler to invest in
- Frequent taxable distributions
- Require self-directed investing
- Concentrated exposure to individual companies
- Higher volatility but greater return potential
- Lower costs if trading less frequently
- Intraday trading control
- Requires research and analysis skills
- Defer taxes until sold
Should You Choose Mutual Funds or Stocks?
Mutual funds generally suit investors who:
- Desire a “set it and forget it” approach
- Have limited time or interest for security analysis
- Seek to minimize taxes in retirement accounts
- Cannot afford or want exposure beyond individual stocks
- Prefer smoothing volatility over maximizing returns
Individual stocks generally suit investors who:
- Actively follow and research companies
- Enjoy stock picking as a hobby
- Have sufficient assets for adequate diversification
- Prioritize tax minimization and control in taxable accounts
- Aim to maximize long-term total returns as a goal
- Embrace volatility as part of the investing experience
Most portfolios effectively blend mutual funds and stocks to optimize the strengths of each.
There is no definitively “superior” investment vehicle. Both mutual funds and individual stocks have advantages and disadvantages that will appeal to different investors based on their goals, preferences, skills, and tendencies.
Mutual funds provide a simpler, more diversified, and professionally managed approach. But stocks offer more potential upside and greater tax and trading control for savvier DIY investors.
As with most investment decisions, striking the right balance depends on the specific needs and profile of each investor. A prudent portfolio often combines both mutual funds and individual stocks to achieve optimal diversification tailored to the owner’s objectives and risk tolerance.
Frequently Asked Questions
Do mutual funds provide any tax benefits versus stocks?
Yes, owning mutual funds in tax-advantaged accounts like IRAs shields investors from capital gain distributions and other taxable events within the fund. This benefit does not apply to taxable accounts, where mutual funds are often less tax-efficient due to trading activity.
Can mutual funds outperform the overall stock market?
Yes, a minority of actively managed mutual funds do succeed in outpacing broad market indexes over extended periods, although most fail to match market returns after fees. Index mutual funds match market returns less fees by design but never underperform or overperform meaningfully over the long run.
Is it riskier to buy individual stocks or mutual funds?
Individual stocks carry greater investment risk due to lack of diversification and exposure to company-specific risks. Mutual funds mitigate overall risk by providing diversified exposure to dozens or hundreds of securities across multiple industries and sectors.
Do mutual funds pay dividends like stocks?
Yes, mutual funds invest in various dividend-paying stocks and ETFs. As these underlying holdings earn dividends, the mutual fund pools and passes through these dividend payments to shareholders periodically. Actively traded mutual funds may also distribute taxable capital gain dividends.
What is the minimum investment for most mutual funds?
The minimum to open a mutual fund account directly with a fund company is typically $1,000 to $3,000. Some funds have higher minimums of $10,000 or more. Investors can also invest small dollar amounts into funds through a brokerage account without minimums but may incur trading fees.
Can you trade mutual funds like stocks?
Yes and no. Unlike individual stocks, mutual funds only trade once per day after the market closes when the net asset value (NAV) is calculated. But mutual fund shares can be bought and sold on demand like stocks when markets are open. There is daily liquidity but no intraday trading.
In another related article, A Beginner’s Guide to Investing: How to Start Investing Your Money