Investors have an almost endless array of different approaches and types of assets to consider. Some investments pose a greater risk than others, but may also bring with them a greater potential for returns. Conversely, some investments may offer lower volatility in exchange for reduced returns.
Two common investments include stocks and mutual funds. Both of these can be added to an investor’s portfolio and have the potential to increase in value over time. But what is the difference in stocks versus mutual funds? And what can investors typically expect when investing in individual stocks or trading in mutual funds?
What is a mutual fund?
A mutual fund is a pooled investment that combines many different securities into one big group, or fund. These securities may include a combination of stocks and bonds, short-term debt, and more. This bundle of assets can help an investor diversify their portfolio, potentially producing acceptable returns that are balanced by limits on risk.
Investors who purchase shares of a mutual fund are, in essence, purchasing shares of the securities held within the fund. If those securities gain value, the value of the mutual fund itself grows as well. Investors will then recognize this growth through increased fund share values, quarterly dividends, and even so-called capital distributions when the fund sells assets for a profit.
Mutual funds have a lot in common with other bundled investment products, such as exchange-traded funds (ETFs). Both allow investors to add many different securities to their investment portfolio with a single share, helping to achieve diversification and contain risk.
However, when comparing an ETF versus a mutual fund, it’s important to note that ETFs can be traded like stocks (at any point in the trading day), whereas mutual funds trade just once at the end of the trading day. ETFs are almost all passively managed, meaning they usually try to match the performance of an index, such as the Standard & Poor’s 500 Index, whereas mutual funds are generally actively managed by investment professionals who select the assets with a specific goal in mind.
There are also some similarities when it comes to index funds versus mutual funds. Both involve a group of investment assets, offer many of the same protections, and may even be the same product in some cases, such as an index mutual fund. However, an index fund is designed to passively follow a specific stock market index, rather than to outperform the index.
What is a stock?
Stocks, also known as equities, are investments that represent fractional ownership of an individual company. Each share offers an investor the proportional benefit of any growth in value or earnings of that company.
What is the main difference between mutual funds and stocks?
The biggest difference between mutual funds versus stocks is diversity.
Buying stocks means buying an ownership share of a single corporation, representing a very specific asset. A mutual fund, on the other hand, combines many different assets—including individual stocks—into one grouping. They tend to be less volatile and risky than individual stocks.
Another key difference is fees. Since mutual funds are overseen by a fund manager and are often actively managed funds, there are annual costs incurred, called expense ratios. Individual stocks do not incur these same fees and expenses, although buying and selling shares can incur expenses.
What are the potential pros and cons of investing in mutual funds?
Mutual funds offer investors diversification, but come with fees that can eat into returns.
Potential benefits of investing in mutual funds
- Reduced risk. Compared to individual stocks, mutual funds can help investors protect their portfolio from market downturns, take advantage of certain upswings, and even hedge against inflation in the long-term.
- Diversification. Rather than investing in a single security, mutual funds combine tens, hundreds, or even thousands of securities into a single fund. This allows investors to create a diversified portfolio.
- Less effort. Rather than requiring investors to rely on their own research and expertise, mutual funds are convenient, curated products that are then actively managed. Investors don’t need to research each individual investment, saving them both time and energy.
Risks of investing in mutual funds
- No guarantees. Even though mutual funds offer diversification and some protection from market volatility, they aren’t a sure bet. While the average risk in mutual funds can be lower than in other types of investments such as individual securities, they are not risk-free.
- Fees. Most mutual funds are actively managed, and they charge annual fees. These fees, called the expense ratio and expressed as a percentage, are subtracted from the value of the fund’s shares. These fees can eat into the fund’s gains.
- Limited trading. Compared to many other investments, which can be traded throughout the day, mutual funds can only be purchased or sold at the end of the trading day.
What are the potential pros and cons of investing in stocks?
Stocks are easy to buy and don’t come with fees, but investing in individual companies takes time and skill.
Potential benefits of investing in stocks
- They can be traded at any time. Investors can buy or sell shares of individual stocks at any time during the trading day. This may allow them to take advantage of dips in purchase prices or jumps in selling prices.
- No added fees. Unlike mutual funds, which are overseen by a fund manager, individual securities do not incur expense ratios. When filling a portfolio with stocks, investors have the potential to reap profits without any added annual costs.
- Simple to buy. Many online brokerages make it easy for investors to buy and sell shares of stock without a commission, typically in just a matter of seconds. In fact, many high-priced stocks can be purchased as fractional shares (a portion of a single share), making them accessible even to entry-level investors.
Risks of investing in stocks
- Investors will need to do their homework. Choosing the right individual stock often requires research, as well as a knowledge of that company, its specific industry, and even the stock market as a whole. If the value of that one particular stock falls, the investor will lose money.
- Prices can fluctuate wildly. Stock prices can ebb and flow throughout the trading day or longer periods during bull and bear markets. Few investors, including many market professionals, have the skill needed to time their purchases or sales to profit or avoid losses. This can be a stressful, costly and time-consuming process.
The bottom line
Many investors will choose a diversified approach for their investment portfolio, often including both bundled investments such as mutual funds and ETFs, and individual securities such as stocks. Each investment type has benefits and drawbacks, depending on the investor’s willingness to trade off potential profits against the risk of volatility and losses. Both types of investments can have their place in a well-rounded portfolio.