Owning individual stocks or mutual funds—which is the better way to invest? It’s really an open question and perhaps it will always be. Which one you choose may have more to do with your own investment experience (or the lack of it), confidence level or even the amount of time you have to work on your investment portfolio.
Comparing Individual Stocks with Mutual Funds
What are some of the reasons an investor would want to hold either?
The individual stock advantage
- Very specific investment plays. This is one of the most compelling reasons to own individual stocks—it’s a direct play on the winners. In every sector there are companies that outperform their competition and provide superior investment returns. By owning the best performers in a sector, your chances of beating the market are substantially better.
- Greater control over your investment mix. Funds contain winning stocks, but in an effort to achieve diversification they also tend to hold a number of laggards, as well. With individual stocks you can choose to own the best performers—or get out of companies that are no longer leaders.
- Greater upside potential. Because of the number of stocks they hold, mutual funds often do little better than track the market. This is especially true of larger funds, which need to invest billions of dollars. By buying individual stocks, the chance that you can do substantially better then the market increases because you aren’t bound by requirements to diversify or to be in nearly every stock in the sector.
- The chance to make a “big killing.” OK, this gets to the heart of why we want to invest in individual stocks. Every now and again a stock explodes and produces not double-digit returns, but triple-digit returns. Just one or two of these per year can juice the returns on any portfolio. It plays into the “get-rich-quick” desire in all of us. Do you think this can happen with a mutual fund?
- The better play for the seasoned investor. There is a point at which you might accumulate enough knowledge and experience that picking and managing your own investment portfolio is a natural evolution. If you learn to spot winning stocks and can do it consistently, you can outperform mutual funds for all of the reasons already discussed.
The mutual fund advantage
Picking the right mutual funds can offer investors more variety and market exposure than average investors can assemble on their own. Here are some other advantages:
- Dollar-cost averaging. Many investors prefer to build their investment portfolio gradually through dollar-cost averaging. This can be done through payroll contributions—typically to retirement accounts—or some other periodic method. This generally works better with mutual funds than with individual stocks since it can be difficult and costly to add small additions to stock positions. Mutual funds are virtually set up to do just that.
- Diversification. When you buy into a mutual fund you don’t have to worry about diversification—that’s the very purpose of the fund. You can diversify among various sector funds but, even if you do, all you need to concern yourself with is the allocation, not the stock selection.
- Professional management. With the possible exception of diversification, professional management is probably the single best reason to go with mutual funds. Let’s face it, most of us are not investment professionals—we have “day jobs” and prefer to turn the job of investment selection and management over to someone who does it for a living.
- Lower transaction costs. Building a portfolio of individual stocks is a lot like building your own mutual fund. In the process, you’ll pay more in commissions and fees for your stocks than you will for an equivalent amount of money invested in a single mutual fund. This is especially true when you’re dealing with odd lots or fractional shares. No-load provisions stack the deck even more in favor of mutual funds.
- Lower downside risk. The very same diversification that keeps the mutual fund holder from “making a killing” also prevents him or her from losing everything. For most investors, this is a welcome trade off. Half of investing success is not losing money, and investing in mutual funds better accomplishes this.
- Buying sectors. There’s a mutual fund for nearly every sector in the known universe. This makes it much easier for the novice or intermediate investor to diversify into investment niches. Don’t know much about energy or biotech stocks? No problem, there’s a fund out there that can take care of the knowledge part for you. All you need to know is when and how much you want to invest.
The Best of Both Worlds
Fortunately, when it comes to investing you don’t have to make the either/or choice with individual stocks and mutual funds. You can do either or both. The less knowledgeable you are about investing, the more important mutual funds are. If you’re a beginner, you should stick with mutual funds.
As you gain experience, you can begin moving slowly from mutual funds into individual stocks, increasing the allocation as you become more confident and successful. But even for the seasoned investor it can still be advantageous to hold the bulk of your money in funds—where professional managers are paid to keep an eye on things—while investing on the side in individual stocks that look like particularly good plays.