New investors looking to invest for the future are usually faced with two main options – mutual funds or individual stocks. Mutual funds are actively managed baskets of stocks, designed to beat the market with the assistance of a fund manager. Individual stocks can be bought by any investor through a brokerage, and it becomes the responsibility of the individual investor to maintain his or her portfolio. Mutual funds are widely regarded as a passive form of investing, while investing in individual stocks is a more active form. Both carry inherent advantages and risks, and it is important for investors to understand the differences between them.
Most beginner investors start with mutual funds, since they are automatically diversified, and present investors with a large variety of flavors – from sector based funds such as tech, financial, retail or energy to commodities to foreign indexes. Mutual funds generally hold a large number or stocks, with each equity only comprising a small percentage of the portfolio. This is both its strength and weakness.
For example, a tech mutual fund may claim Apple as one of its top holdings, but a rally in Apple shares may barely move the mutual fund, on account of Apple only comprising 2% of the overall portfolio, and the remaining 98% being comprised of industry laggards such as Cisco. In this same example, however, a crash in Apple shares will also be cushioned by its low portfolio weight and buffered by other less volatile stocks. Although the growth of mutual funds may be limited, the downside is limited as well.
When purchasing mutual funds, investors usually don’t define the exact number of shares to purchase; rather, they will order a set dollar amount from a brokerage, and the brokerage will calculate the shares to be bought based on the day’s closing price. It is also important to remember that the share price of a mutual fund does not fluctuate during the day – it is only reported after the market close based on the closing prices of all of its underlying securities. Investors interested in actively trading mutual funds should invest in ETFs (exchange traded funds), which were designed for that purpose.
Mutual fund investors should allow a longer time frame, in terms of years, to observe slow and steady growth. They should also make regularly scheduled investments, to take advantage of dollar cost averaging. For example, investing $1000 a year in the same mutual fund without regard to the share price will insure moderate growth, by purchasing more shares when the price is low and fewer shares when the price is higher. In addition, investors who do not intend to use the fund’s dividends as income should use an automatic dividend reinvestment plan – which automatically uses the dividends to purchase more shares (or fractional shares) of the same fund, as a form of dollar cost averaging. This not only allows investors to sidestep the capital gains tax on cash dividends, but also the brokerage commission charged for purchasing additional shares.
Each mutual fund has its own set of fees and expenses. These can include, but are not limited to – the fund manager’s fee, a front-end load upon initial purchase, a back-end load upon sale, as well as early redemption charges. It is important to understand the complex fees of mutual funds in the prospectus before purchasing any shares, as the purchase equals a binding agreement to pay these extra charges. For investors who favor mutual funds but want to avoid the fees, index funds, which are passively managed mutual funds which simply mirror a set market index, such as the S&P 500, may be a better lower-cost alternative.
For the more adventurous investor who is not satisfied with the lower returns of mutual or index funds, picking individual stocks for a personal portfolio is the favored choice. Purchasing individual stocks can be done directly through any brokerage, with the only fees being the commission paid upon the purchase of shares and the capital gains tax paid upon sale. Investors define exactly the amount of shares to purchase, and the desired price. Dividends from individual stocks can also be reinvested into the company, with the same aforementioned advantages of mutual funds – dollar cost averaging and sidestepping the capital gains tax.
Investing in a single company can be a high risk, high reward affair – investing $1000 in a company could either result in a complete loss of the principal or an exponential increase of the investment, something which could not occur in the slow and steady world of mutual funds. To offset this risk, however, most investors will choose a small basket of stocks to counterbalance each other to diversify and minimize risk. As a general rule of thumb, the more stocks in a portfolio, the better it is protected from volatile market movements. Investors in individual stocks should also be well studied in market terminology and be well read in daily financial currents to assess the state of their portfolios, paying careful attention to quarterly earnings, commodity prices, unemployment reports and interest rates, to name a few. Generally, investing in individual stocks is a task best done by investors with more time on their hands. In addition, each share of stock is a piece of the company and counts as a vote during shareholders’ meetings. An investor investing a large amount of capital (in the millions) may hold considerable sway over a company’s operations.
Individual stocks are also a far more emotional affair than mutual funds. Whereas a drop of 10% in a mutual fund may be depressing, a 30% loss in a single stock is hardly out of the ordinary – and while many investors get tempted to sell at the bottom, patient investors know when to use these dips to increase their holdings of undervalued stocks. Likewise, many investors get pulled in by financial hype and buy stocks at all-time highs only to panic later during a pullback. Stocks have no guarantees – a bankrupt company can liquidate all its shares and leave investors with nothing.
If you are unsure about which investment is right for you, consult a financial advisor — it is best to fully understand your investment time frame and risk tolerance limits before committing to mutual funds or stocks.