One of the common questions beginner investors ask is if they should pick their stocks or buy shares in a mutual fund. Mutual Funds are companies that pull together money from individual and corporate investors to invest in stocks. Picking individual stocks is a process that involves researching listed companies and deciding on what companies’ shares to buy.
Advantages of buying Mutual Funds
Some of the benefits that come from investing in mutual funds include:
The first and probably the most important is the level of diversification it provides. A mutual funds purchase shares from different companies in different sectors, with different sizes and structures. In this way, they reduce the unsystematic risk related to investment. For example, a mutual fund that has shares in fifty companies spread across various industries, sizes, and structures. The failure of one of these companies or a downturn in one of the sectors will not prove so fatal if the other companies or the other sectors are performing well.
But if an individual has shares in three or four companies, the effect of the failure of one of the companies is more pronounced on the overall portfolio.
So purchasing mutual funds reduces unsystematic risk and reduces the potential loss that can result from the failure of a company or a sectorial downturn.
Generally, purchasing mutual funds come with less efforts. When you want to decide what mutual funds to buy, it is a singular decision. You only need to evaluate the performances and profitability of the fund as a whole and make your decision.
However, with individual stocks, you have to do a company by company analysis of every stock you want to purchase. After purchase, you will need to keep a tab on each company and monitor their performances. With mutual funds, you only need to focus on the performance of the fund as a whole.
In many cases, the fees associated with buying mutual funds are lower compared to buying individual stocks. Mutual funds incur expenses, and management fees spread out over all the investors in the fund. When you buy or sell individual stocks, you pay brokerage fees. For people who buy and sell frequently, the brokerage fees can add up to a significant amount. Generally, the fees you will pay on mutual funds will be lower. Mutual funds fees also vary depending on whether it is an actively managed mutual fund (a fund that seeks to outperform the market) or an exchange-traded mutual fund (a fund that seeks to keep up with the performance of the market).
There are different options when it comes to mutual funds. We have managed funds, exchange-traded funds, index funds (funds that seek to match the performance of a particular index), and no-load funds (no management fees). Also, many funds will provide you with a variety of options that matches your risk appetite. There are funds with a certain percentage of equity mixed with a certain percentage of bonds. There are aggressive growth funds and other funds that mix stocks with fixed investments.
Mutual funds offer flexibility that can help you achieve your goals.
Managers of mutual funds are finance experts and professionals who have more knowledge than most people. They bring a great deal of knowledge and expertise to the table that the average investor may lack.
Advantages of buying individual stocks
Possibility of Higher Returns
Picking individual stocks can lead to higher returns if you make the right choices. Most mutual funds won’t grow at the same rate that some high performing stocks will grow. This is because the growth rate of that particular stock may balance out the other stocks in the fund. Choosing a few high performing stocks can, therefore, lead to a very high return beyond what mutual funds can achieve.
Mutual funds will change the stocks they hold based on their evaluation of the profitability of the stock into the future. You don’t have control over such decisions, and the portfolio of the mutual fund, at any time, will be different from what it was when you bought in.
When you pick your stocks, you have control. A mutual fund may sell a stock of which you have the conviction that it will grow into the future. You cannot control that. But when you buy your own stocks, you can follow your convictions.
Possibility of lesser fees
For investors who buy and hold stocks for the long term, the fees associated with picking individual stocks can be lower than the fees associated with buying mutual funds.
Making a Decision
So which approach should you take?
The decision will depend on many factors. Before making a decision, ask yourself the following question:
- Am I comfortable spending a lot of time researching individual stocks and following the market to evaluate performances?
- Do I have the requisite knowledge to conduct this research? Do I have the time or interest to learn?
- What is my risk appetite? Is the possibility of higher returns strong enough to take the higher level of risk?
- Do I have a strategy to outperform the market? Can I do it better than the experts?
- Am I an anxious person who easily gets worked up and emotional looking at price trends?
- Do I have the skills to identify stocks that can give the kind of returns that will make picking my stocks worth it? Do I have the patience or emotional stability to deal with downturns and uncertainties?
- Do I have enough money to achieve a certain level of diversification if I pick my stocks?
- What are my overall goals? How will the level of risk associated with picking individual stocks affect my overall goals?
- Do I have financial experts that I can trust their judgment on what stocks to pick? Can I pay the fees? Are they better than the managers of funds?
Above are ten questions you must ask before deciding whether to invest in mutual funds or buy individual stocks. Of course, there are more nuances to the issue than the above, but these should give you a starting point to make an intelligent decision.
Where and how to invest your money are important personal finance decisions. Do not make arbitrary and hast decisions. Ask important questions. Follow important guidelines. It is also important you understand yourself. No one understands your personality and situation more than you do. Most importantly, always keep your long term goals in mind. Every decision you make must flow out of what your long term goals are. The returns you pursue and the risks you take must flow out of your long term goals.