Should You Invest in Mutual Funds or Stocks?

Risks and Returns of Each

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Whether you invest in mutual funds or stocks depends on three factors. First, you must decide how much risk you can tolerate versus how much return you want or need. If you want a higher return, then you must accept a higher risk.

It also depends on how much time you have to research your investments. That includes how much you enjoy researching financial statements or fund prospectuses.

The third factor is what type of fees and expenses you are willing to endure. If you plan to buy and hold, you don't want annual fees. You've also got to consider the tax implications.

The Difference Between Stocks and Mutual Funds

When you buy a stock, you are owning a share of the corporation. You make money in two ways. Stocks that offer dividends will pay you something every quarter or year. That provides an annual stream of taxable income.

You also make money from stocks when you sell them. Your profit is the difference between the selling price and your purchase price, minus fees. Stocks trade continuously, and the prices change throughout the day. If the market crashes, you can get out anytime during the trading session.

Mutual funds pool a lot of stocks in a stock fund or bonds in a bond fund. You own a share of the mutual fund. The price of each mutual fund share is called its net asset value. That's the total value of all the securities it owns divided by the number of the mutual fund's shares. Mutual fund shares are traded continuously, but their prices adjust at the end of each business day. That's not good if the market is crashing.

There are two types of funds: managed and exchange-traded. Actively-managed funds have a manager who seeks to outperform the market. As a result, their fees are higher. Exchange-traded funds match an index so their costs are lower.

There are many categories of stock funds. This allows you to focus on a particular type of company, such as small or large. You can also focus on a specific industry or geographic location. You can even pick a trading strategy, such as bear market or short fund.

Bond funds invest in securities that return a fixed income. They are safe but provide a low return. They vary by bond duration, with money market funds being the shortest duration and the safest. They also vary by type of bond, such as corporate or municipal. Some also vary by level of interest rate. The highest rates are the riskiest.

Risk-Return Tradeoff

Stocks are riskier than mutual funds. By pooling a lot of stocks in a stock fund or bonds in a bond fund, mutual funds reduce the risk of investing. That reduces risk because, if one company in the fund has a poor manager, a losing strategy, or even just bad luck, its loss is balanced by other businesses that perform well. This lowers the risk, thanks to diversification. For that reason, many investors feel that mutual funds provide the benefits of stock investing without the risks.

For example, any fund in 2008 that held Lehman Brothers stock would have declined with the bank’s demise. But investors who held only Lehman Brothers stocks would have lost their entire investment. 

The tradeoff is that most mutual funds won’t increase as much as the best stock performers. For example, Amazon’s stock price has risen 61,600 percent since 1997. The was Vanguard Health Care. It only rose 2,247 percent over the last 20 years. Even so, it’s better than super-performer 1,000 percent since 1998. So, even though there is a trade-off, the best mutual funds do very well when compared to many stocks.

Time Available

The second factor is how much time you want to spend on research. To learn about investing in stocks, you need to research each individual company. You must learn how to read financial reports. They tell you how much money the company is making and what strategies it is using to grow earnings. You also must stay on top of how the economy is doing and how that will affect the company and its industry. Unless you do this, you won't be able to pick successful companies. You'll miss the industries or sectors that are on the upswing.

As you can imagine, you'll need to do a lot of research to build your own diversified portfolio. You'll need to pick companies with different sizes, strategies, and industries. You might investigate dozens of companies to find a few good ones. This takes too much time for most people with full-time jobs and families.

Mutual funds don't require as much time to research because the manager does that for you. But you still need to research the past performance of the mutual funds. You also need to decide which sectors seem most promising. Of course, you still need to know how the economy is doing.

Mutual fund research has its own set of challenges. The managers constantly change the companies they own in their portfolio. The prospectus could be from an earlier period, so you don't really know what you are getting today. You can look at past performance. But if a manager changes the portfolio, the performance won't be the same.

Costs and Fees

Brokers charge you when you buy or sell the stock. But those fees can vary depending on the services you receive. If you are savvy enough to select your own stocks, you will pay less. If you want advice so you can outperform the market, you will need a full-service broker. That costs more. If you're a buy-and-hold investor, this might work best for you. Once you own the stock, the broker won't charge you until you sell it. 

Mutual funds charge annual management fees. Some charge when you buy the fund, others when you sell the fund, and others don't charge at all if you hold for a certain length of time. A few, called no-load funds, charge no fees. All funds also charge annual management fees. Some funds require a minimum investment.

Most actively-managed funds buy and sell stocks throughout the year. If they incur capital gains on those stocks, you may have to pay taxes on it. That's true even if the overall value of the mutual fund declines. For that reason, many people prefer holding mutual funds in a tax-advantaged account like an IRA or 401 (k).

Exchange-traded funds charge lower fees. Like stocks, they only charge when you buy or sell shares of the fund.