Here is the ultimate dilemma a beginner investor faces; ‘stocks or mutual funds?’ That is, which one should a beginner investor choose to invest his/her money in.
Before we move on to answer that question (Yes, I will settle that debate once and for all), let’s look at mutual funds and stocks in detail and understand how they make money.
Mutual funds vs stocks
First off, mutual funds and stocks are interconnected. Because most mutual funds are comprised of stocks. These mutual funds that are comprised of stocks are known as equity mutual funds.
Now, let’s lay out the differences between a mutual fund and a stock.
A mutual fund pools money from investors to buy securities. The securities mostly vary between stocks and other fixed-income securities like bonds. A stock represents a portion of the underlying company. By owning a stock, you’re owning a portion of the company.
Mutual funds have Net Asset value (NAV), which is the fund’s market value per share. Which is roughly the equivalent of the share price of an individual stock.
Mutual fund investors make money when they sell the shares of the fund. And if it is a mutual fund that is focused on dividend stocks, you might receive a dividend once in a while. The same goes for stocks; you make money when you sell the stock, and when the company issues dividends.
These are just a few of the basic differences between a mutual fund and a stock. However, when it comes to deciding which investment vehicle should you choose, it all comes down to one thing and one thing only.
How much money is it going to make?
And certainly, it’s not that simple. But your objective as an investor is to grow your money. So naturally, you should choose what’s best for that.
Keeping that in mind, let’s look at the two factors that determine your profit; returns and cost. The returns are the money you make from your investment. Cost is what you should be willing to spend to achieve the expected return. Cost includes both the money you spend towards fees and commissions and the time you spend on doing the necessary due diligence.
Let’s analyze mutual funds and stocks based on these factors.
Returns; Mutual funds vs stocks
Mutual funds pool in money from investors to buy assets – mostly stock. And they aim to maximize returns for the investor. Generally, mutual funds are actively managed funds. They are run by finance professionals who are known as mutual fund managers. A fund manager decides where to invest and how much to invest.
Stocks, on the other hand, can be bought by anyone with money and a brokerage account. And they can do that either passively or actively.
One of the factors that investors associate with returns is risk. Now, the amount of risk that an investor can tolerate varies from person to person. I am fine with having my stocks go down 30%-50% at times. I can live with that. But that might not be the case for every investor.
People mostly choose mutual funds as they see them as a less risky investment. But guess what? They also generate lower returns.
Individuals tend to assume that mutual funds are the better option. Especially in terms of returns, as they are managed by finance professionals. Well, let’s take a look at these numbers;
As you can see over the last 10 years, mutual funds have had an annual average return of 12.02%. Over the same period, S&P 500 has had an average return of 13.6%.
And there’s more.
Take a look at this data from S&P Dow Jones;
Over a 15 year period, 92% of large-cap mutual funds have failed to beat the market.
Yes, that’s right – 92%.
Don’t forget that this is despite paying the fund manager huge fees every year. This goes to say, if you choose mutual funds you’re likely to underperform the market in the long run. Mostly because mutual funds tend to be conservative about their investment choices. They care more about reducing the downside risk than growing money.
But that’s not the case with individual stocks. If you pick the right stocks for your investment strategy, you can enjoy significantly higher returns than the market average.
Take Apple, for example, a $1,000 investment made in June 2011 would be worth $11,628.19, as of June 2021. That’s a 1,062.82% gain in just 10 years.
Costs: Mutual funds vs stocks
Costs include both the money you spend towards fees and commissions, and the time you spend on research.
Mutual funds are created by financial institutions and regulated by the Securities and Exchange Commission. And they are run by financial professionals known as fund managers. They decide which companies to invest in. By investing in a mutual fund, you’re just following suit.
Also, every mutual fund has something called an expense ratio. You can think of it as a management fee. It is the amount you need to pay as fees for investing in the mutual fund. It is represented as a portion of your mutual fund investment. For example, if you invest $10,000 in a mutual fund, and the fund has an expense ratio of 2%, you’ll pay $200 annually towards fees.
The fees must be paid no matter what. Even if the fund is underperforming the market.
Stocks, on the other hand, don’t cost you much apart from the stock price itself. Earlier, there were all kinds of fees and commissions associated with buying stocks. But with the arrival of discount brokers like TD Ameritrade and WeBull, you can buy stocks with zero commission. And unlike mutual funds, you can choose your stocks.
And even if you don’t want to buy individual stocks, there are better alternatives to mutual funds. Take an index fund for example. Index funds are passively managed funds that track and index. Which means you’ll get the same returns as that of the market index. And fees are less compared to mutual funds. You could also go for exchange-traded funds (ETFs)
Time: Mutual fund vs stock
If we talk about time spent, researching stocks can take up quite a bit of time. Especially, if you’re relatively new to investing. But despite what the mainstream media tells you, you don’t need to know everything from the oil prices to the latest trends in the market. To successfully pick individual stocks you only have to know the basics of how a company operates. Specifically, how they make money and how they spend their money.
Of course, that’s not all. You would need to learn to find information from Annual Reports, Form 10-Ks, etc. But the point is, it can be done. You don’t need to have a degree in finance to do that. Just plain old common sense is enough.
However, it is true that mutual fund investments do not take up as much time as you need with researching individual stocks. But in the long term, it’s worth it, as your returns are likely to significantly outperform the market average and the returns from mutual funds.
And we shouldn’t forget taxes. Mutual funds are not particularly great for your capital gains taxes. Capital gains tax is generally incurred when you sell your investment and make a profit. But mutual funds buy and sell stocks throughout the year. That means, even if you don’t buy or sell your mutual fund shares, you’ll still incur taxes. Even when the mutual fund is not making good returns, you might incur capital gains taxes due to the nature of the fund.
But with stocks, you’ll only incur taxes when you sell stocks and when you receive dividends. And long term investments are taxed at a lower rate than short-term investments. So if you hold on to your investments longer, you’ll make more money and you can pay less in taxes.
Both stocks and mutual funds help you in building up a diversified portfolio. But the key difference is as a mutual fund investor you’re likely to underperform the market in the long run. Mainly due to high fees, and relatively poor returns.
But if you’re not sure about how you can start with individual companies, check out our 8-step Beginners Guide. It has a list of 20 stocks that you can confidently own for the next 20 years.