Leaving money in a stagnant bank account guarantees that inflation will gradually reduce your purchasing power. Most bank savings rates don’t keep up with inflation, and even if they do, the interest payments get taxed as ordinary income.
Investing in various assets can help investors beat inflation and reach their retirement goals sooner. Mutual funds and stocks are both useful starting points because they are very liquid and don’t require much capital. You can get started with as little as $1; by contrast, real estate properties often require hefty down payments.
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Mutual funds and stocks each have their strengths and weaknesses as investments. This guide will explore some of the differences and help you determine which type of asset is right for you:
— The difference between mutual funds and stocks.
— Pros and cons of mutual funds.
— Pros and cons of stocks.
— Should you buy stocks or mutual funds?
— Creating an investment strategy.
The Difference Between Mutual Funds and Stocks
Mutual funds and stocks both trade on public exchanges and give you access to the shares of your favorite companies. However, mutual funds require less work and offer instant diversification. Many mutual funds hold hundreds of stocks, and a dedicated fund manager oversees the portfolio. You will have to pay a small annual fee, or expense ratio, to hold onto your mutual fund shares. This fee is taken off the value of each share.
You can avoid fund fees by investing in individual stocks instead. Investors can still achieve portfolio diversification by accumulating multiple stocks, but you have to analyze the underlying companies and monitor your holdings.
Pros and Cons of Mutual Funds
Mutual funds have several advantages over individual stock picking. Beyond diversifying your holdings, some mutual funds aim to outperform the stock market, while others mirror a popular index like the S&P 500.
Kendall Meade, a financial planner at SoFi, highlights some of the key advantages that mutual funds provide: “The advantage of mutual funds or ETFs over individual stocks is that they provide more diversification and are more hands-off. I like to describe them as baskets of stocks. Instead of choosing a stock, you have hundreds,” Meade says.
You can buy mutual funds and barely monitor your investment portfolio. It’s easier to set up automatic transfers to these funds as well. If you want to save time while achieving good returns, mutual funds can help.
However, mutual funds also require that you give up some control. Jason Bernat, CEO of American Financial Services, mentions some of the disadvantages to keep in mind: “When you invest in mutual funds, you give control to the manager. You can’t control capital gains. You don’t control the individual holdings, and if you want to sell them, you have to wait until the end of the day. There is a management fee for all of this built into the fund.”
Some investors are fine with giving control to a seasoned professional. However, other people may prefer to manage their own holdings. If you review a fund and don’t like some of its holdings, there’s not much that you can do about it other than picking a new fund. You can also end up with high capital gains even if you do not sell a single share. It all depends on the fund’s objectives and who is managing it.
Pros and Cons of Stocks
You don’t have to rely on a fund manager when you invest in stocks. If you find a great opportunity, you can accumulate shares and adjust your portfolio accordingly. It’s also possible to get rid of stocks right away instead of being stuck with them in a mutual fund.
“By investing in individual stocks, you can control your portfolio and the capital gains. You can also control the holdings and diversification. When you want to sell that position, it sells immediately,” Bernat explains.
Investing in stocks gives people the potential to outperform mutual funds and broader indexes. However, potential doesn’t always match up with end results. Although it’s possible to outperform the stock market with individual picks, Meade has a few words of caution. “Technically, if you look at the data, passive investing tends to outperform active investing. This is mostly due to the fact that we are human and we make mistakes or react on emotions.”
You will have to ride the emotional highs and lows of investing if you buy individual stocks. Mutual fund investors are less susceptible to emotional decisions because they invest in a single fund or several funds rather than numerous stocks.
Buying individual stocks also takes more time. You have to research individual companies, look at earnings reports, compare competitors and learn about how the stock market works. Even once you have the foundational knowledge, you still have to monitor your investments to ensure they have the same catalysts as they did when you first purchased the shares.
Should You Buy Stocks or Mutual Funds?
Stocks are more appropriate for investors who can monitor their portfolios and the stock market for opportunities. Mutual funds are more suitable for investors who want a fund manager to do all of the work for them. Bernat summarizes what investors should consider before choosing the right approach for their portfolio.
“If you want more control over your portfolio, including taxes, risk, liquidity and lower costs, then individual stocks would benefit you. If you as an investor are looking for professionally managed accounts that are diversified, and you are ok with ongoing management fees, then mutual funds would be an adequate investment,” Bernat says.
Both approaches are viable, but you don’t necessarily have to choose between one or the other. Some investors accumulate individual stocks and mutual funds. The funds offer some risk protection, while individual stock picking lets investors double down on the high-conviction stocks on their radar.
Passive investors who think they can buy shares in a single mutual fund and call it a day may want to consider additional funds. While mutual funds offer more diversification than individual stocks, most funds focus on companies that fit specific parameters, such as market cap, exposure to a certain sector or something else. So, you may still need some diversification after investing in a mutual fund.
“The S&P 500 just invests in the 500 (leading) U.S. companies. You are not invested in medium-sized U.S. companies, smaller U.S. companies, bonds or international companies. For this reason, if you are investing on your own, you may want to invest in multiple indexes so that you participate in all of these markets,” Meade says.
Creating an Investment Strategy
Deciding whether to buy stocks or mutual funds is one part of creating an investment strategy. You can decide to focus on these assets or distribute your capital across real estate, precious metals and other asset classes.
Individuals can get exposure to many investment opportunities, but it’s important to know your goals before you invest your capital. Having a timeline for certain goals can also lead to more prudent decisions.
“Your investment strategy should be developed around your goals, time frame and risk tolerance. After all, money that you plan to use in five years to buy a house should be invested more conservatively than money you plan on using in 25 years for retirement,” Meade says.
Stocks and funds geared toward growth can generate outsized returns and help investors achieve long-term goals sooner. However, growth stocks and funds tend to exhibit more volatility. For that reason, investors approaching retirement tend to invest in less risky, dividend-paying stocks as well as funds that deliver high yields.
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Mutual Funds vs. Stocks: Which Are Better Investments? originally appeared on usnews.com
