Why Would Someone Choose a Mutual Fund Over a Stock?

Key Takeaways

Mutual funds pool money together from a group of investors and invest that capital into different securities.
Each mutual fund has a goal that defines its risk profile, investing objective, and overall strategy.
Mutual funds offer diversified holdings in many different industries or types of securities.
Investing in a mutual fund is a good way to avoid some of the complicated decision-making involved in investing in stocks.
Though mutual funds still charge manage fees, the cost of trading is spread over all mutual fund investors, thereby lowering the cost per individual.

Mutual Funds vs. Stocks

Mutual funds offer an individual investor exposure to many stocks, not a few.
The stocks in the fund are selected and managed by professional portfolio managers who do all the work of buying and selling with the goal of meeting or beating the performance of a specific benchmark.
Mutual funds have fees, which can be very low if the fund is passively managed and considerably higher if it is actively managed.

The Basics of Mutual Funds

Mutual funds pool money together from a group of investors and invest that capital into different securities such as stocks, bonds, or short-term securities. Each mutual fund has a different investment objective which drives the strategy and selection of investments within the fund. Each fund has a money manager responsible for the fund, and the manager's objective is to generate income for investors by investing portfolio assets and protecting the portfolio's value. Mutual funds can hold many different securities which makes them very attractive investment options.

Actively managed funds require a portfolio manager who constantly updates their holdings, while a passively managed fund's portfolio is built on a buy-and-hold strategy.

Advantages of Mutual Funds

There are several specific reasons investors turn to mutual funds instead of managing their own portfolio directly. The primary reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.

Diversification

Ask any investment professional, and they'll likely tell you that one of the most important ways to reduce your portfolio risk is through diversification. Instead of investing in just one company, industry, or investment vehicle, there's benefit to spreading your investments across different holdings to minimize potential losses. The less correlation your investments have, the lower the risk of them all dropping at the same time.

Many experts agree that the benefits of diversification are mostly realized when a portfolio holds stock in at least 20 different (and differing) companies. At that point, a large portion of the risk associated with investing has been diversified away. The remaining risk is deemed to be systematic risk that will impact any security you're holding.

Since most brokerage firms charge the same commission for one share or 5,000 shares, it can be difficult for an investor to buy into 20 different stocks. In addition, it's a delicate balance weighing the benefits of varying correlation coefficients with the long-term projected success of a company.

That's where mutual funds come into play. Mutual funds offer investors a great way to diversify their holdings instantly. Unlike individual stocks, investors can put a small amount of money into one or more funds and access a diverse pool of investment options as a single mutual fund may be comprised of dozens of different securities.

Mutual funds also invest in a variety of different sectors. Some of the biggest mutual funds invest in S&P 500 companies or large-cap stocks. Others may specifically target companies with smaller market capitalization or specific industries like technology, health care, or raw materials. Again, if you were to try to match this through individual stocks, you'd have to spend a lot of time selecting your investments.

Convenience

Another reason investors choose this investment option is the convenience of mutual funds. When deciding how to allocate the equity portion of your portfolio, you can defer that decision to an investing expert rather than buy individual shares yourself. Some investors find that buying a few shares of a mutual fund that meets their basic investment criteria is easier than researching companies to invest in and directly purchasing their stock. Investors use mutual funds when they prefer to leave the research and decision-making up to someone else.

This convenience translates into relying on a money manager to help determine your portfolio's asset allocation. People devote their entire careers to learning and understanding the stock market, so it's often more beneficial to rely on their expertise than attempt to learn the industry on your own.

Many mutual funds also offer investors a easy opportunity to buy into a specific industry or to buy stocks with a specific growth strategy. Here are several examples of the different types of easily accessible mutual funds:

Sector funds invest in companies within a specific industry or sector of the economy.
Growth funds focus on capital appreciation through a diversified portfolio of companies that have demonstrated above-average growth.
Value funds invest in companies that are undervalued and are normally held by long-term investors.
Index funds allow investors to track the overall market by constructing a portfolio that tries to match or track a market index.
Bond funds generate monthly income by investing in government and corporate bonds as well as other debt instruments.

Costs

The costs of frequent stock trades can add up quickly for individual investors. Gains made from the stock's price appreciation can be canceled out by the costs of completing a single sale of an investor's shares of a given company.

With a mutual fund, the cost of trading is spread over all investors in the fund. Therefore, the mutual fund capitalizes on economics of scale and often results in a lower cost per individual than if those individuals were to self-purchase the investments. Many full-service brokerage firms make their money off of these trading costs, and traders may find they are charged for every buy or sell order they place.

Most online brokers have mutual fund screeners on their sites to help you find the mutual funds that fit your portfolio. You can also search out funds that can be purchased without generating a transaction fee or funds that charge low management fees. Instead of paying fees every time you invest into a mutual fund, the mutual fund will charge an ongoing fee to cover the cost and labor of maintaining the fund.

Advisor Insight

Joe Allaria, CFP®
CarsonAllaria Wealth Management, Glen Carbon, IL

A mutual fund provides diversification through exposure to a multitude of stocks. The reason that owning shares in a mutual fund is recommended over owning a single stock is that an individual stock carries more risk than a mutual fund. This type of risk is known as unsystematic risk.

Unsystematic risk is risk that can be diversified against.

For example, by owning just one stock, you carry company risk that may not apply to other companies in the same sector of the market. What if the company's CEO and executive team leave unexpectedly? What if a natural disaster hits a manufacturing center slowing down production? What if earnings are down because of a defect in a product or a lawsuit? These are just a few examples of the types of things that could happen to one company but are not likely to happen to all companies at once.

There is also systematic risk, which is risk that you cannot diversify against. This is similar to market or volatility risk. You should understand there is risk associated with investing in the market. If the market declines in value as a whole, that is not something that can easily be diversified against.

Therefore, if you'd like to invest in individual stocks, I would recommend researching how you can compile your own basket of stocks so you don't own just one stock. Make sure you are sufficiently diversified between large and small companies, value and growth companies, domestic and international companies, and also between stocks and bonds—all according to your risk tolerance. This is where it might be helpful to seek out professional help when constructing these types of portfolios. Just know, though, that this type of research and portfolio construction and monitoring can take quite some time.

The alternative is to invest in a mutual fund for instant diversification. Of course, there is a list of things to be aware of when choosing mutual funds as well. Fees, investment philosophy, loads, and performance are just a few components to consider when evaluating mutual funds.

Things to Consider Before Investing in Mutual Funds

Before investing in mutual funds, consider the following:

Do you prefer to self-manage your own portfolio by picking your own stocks, or would you prefer deferring this responsibility to a financial expert?
What are your investment goals, and how will this impact the mutual fund you decide to invest in?
What fees are you willing to pay to have a mutual fund manage investments on your behalf?

Are Mutual Funds a Good Investment?

Mutual funds are a good investment for investors looking to diversify their portfolios. Instead of going all-in on one company or industry, a mutual fund invests in different securities to try and minimize your portfolio's risk.

What Are Some Disadvantages of Mutual Funds?

Mutual funds take control out of an investor's hands - instead of picking the companies you want to invest in, you're often limited to what a money manager thinks is best. There are also ongoing management fees associated with mutual funds that may be more expensive than brokerage companies offering low-cost or no-cost individual stock trades.

Are Mutual Funds Safe?

Like all other securities, mutual funds are investments that are subject to losses. However, the goal of a mutual fund is to reduce investment risk, so mutual funds can often be less risky than other types of investments due to its diversification.