Mutual Funds vs. Stocks (Which is better in 2019?)
This article examines the differences between mutual funds and stocks.
The difference between mutual funds and stocks is the same as the difference between having a single egg and an entire hen house of eggs.
A stock represents a piece of one company. A mutual fund holds a bunch of stock.
A single person can own a stock. With a mutual fund, lots of investors pool their money and managers of the fund then choose the stocks the fund will buy using everyone’s money.
The overall idea of using mutual funds vs. stocks is that pooling funds allows everyone to spread their risk over lots of investments instead of just owning one.
What are stocks?
A stock is a tiny piece of ownership in a company. Suppose a company issues 100 shares of stock and you buy 1 share. You own 1% of the company.
Of course, most companies issue hundreds of millions or even billions of shares, so individual investors rarely end up owning significant parts of a company.
The price of the stock you own will rise and fall based upon other shareholders, and their desire to own or sell their stock. The prevailing wisdom is that the growth of a company’s earnings is the primary determination of what investors are willing to pay to own a piece of a company.
What are mutual funds?
Mutual funds are baskets of stocks. A mutual fund pools all the money of many investors, and than invests that money in a basket of stocks. The basket may have 10 stocks or it may have thousands.
The idea is that a mutual fund offers exposure to many different stocks, creating diversification, so that all of your eggs are not in one stock. Sure, that stock may rise, but it may also fall.
With mutual funds, it is highly unlikely all the stocks will rise or fall at the same time, which reduces overall risk.
What are the differences between mutual funds and stocks?
By owning individual stocks, you control how you are constructing a portfolio. You pick and choose the stocks you want, when to buy and sell each of them, and you are limited to only the stocks that you decide you want to own.
You, the investor, own a tiny slice of a company that the stock you purchase represents.
With mutual funds, you are choosing a general investment strategy and leaving it to the mutual fund manager to decide how to specifically execute the strategy with various stock purchases.
He picks the stocks he thinks are best, and you have no say on what stocks get chosen.
You own pieces of many different companies, but technically you actually own a piece of a fund which in turn owns those pieces.
Advantages of Stocks
When it comes to investing in mutual funds vs. stocks, here are the advantages of stocks:
- Ability to do comprehensive research on one investment
- Higher potential reward over time
- Control over capital gain taxation
Here’s a video that gives additional information on investing in stocks.
Ability to do comprehensive research
The biggest advantage in purchasing individual stocks is being able to do a deep dive into the company that the stock represents.
Stocks are required to provide detailed filings at the end of every quarter, which include providing comprehensive information about the company’s profits, assets and liabilities, and cash flow.
Not only can you research the company based on its filings, but there are likely to be countless articles and analyst reports available.
You can spend as much or as little time as you want to determine what you believe the company’s current fair value is, and how much possible growth there might be in its stock price over time.
Higher potential reward
When you invest in a single stock, over the long term, the price of that stock should go up.
In fact, if you look at any of the world-famous brands, and you look at their stock performance over time, there is a very good chance that their stock has returned multiples of investors’ initial investment.
The reason for this is that, if company is successful, it will continue to grow earnings over a very long period of time.
That’s why, if you look at a chart of Coca-Cola, which went public in 1962, you will see that the stock has returned 250 times an investment made at that time.
Control over Capital Gains Taxes
If you made money by selling the stock at a higher price and when you purchased it, then the money that you make is subject to taxation.
The government refers to this as a tax on capital gains.
You decide exactly when you want to sell your stock, and therefore, when you will be taxed.
With mutual funds, many of the stocks in a given basket get sold a regular basis throughout the year. The mutual fund is required to add up all of the gains it may during the year and distribute those before the end of the year to all shareholders.
Thus, mutual fund shareholders do not get to choose when they must pay taxes on those capital gains.
Advantages of Mutual funds
When it comes to investing in mutual funds vs. stocks, here are the advantages of mutual funds:
- Easy to diversify
- Less risk over time
- They do all the research
Here’s a video that gives additional information on investing in mutual funds.
Easy to diversify
The biggest advantage when it comes to mutual funds vs stocks is that the former provides the diversification for you, because a basket of stocks is – by its very nature – diversified.
A properly managed mutual fund will select a variety of stocks that gives the mutual fund exposure to a broad variety of investments.
Thus, by purchasing the mutual fund itself, you have eliminated the necessity of owning a diverse set of stocks yourself.
Less risk over time
Diversification creates less risk, because the more stocks a mutual fund owns, the less likely it is that any one stock – or even several stocks – will all drop significantly at the same time.
So rather than one bad egg spoiling your entire portfolio, you spread risk around an entire hen house worth of eggs.
By the way, if you ever studied statistics, this is where the term “standard deviation” matters. A portfolio of many stocks has a lower standard deviation than just holding a few stocks. That means the average return will deviate less from the average in a mutual fund that by holding one individual stock.
They do all the research
Instead of having to suffer through a long and time-consuming process to evaluate a company and its stock’s values, you can rely on the expertise of the mutual fund managers.
Not only are they likely to have more resources than you do anyway, but they are likely to be experts in a wide variety of investments and companies.
Thus, they do all the heavy lifting, freeing up your time.