Mutual funds vs. stocks: Which option is right for you?
, by Rob Kaufman
Mutual funds... stocks... ETFs... bonds...CDs... TIPs... and that's just the beginning of the list of potential investment vehicles. Unfortunately for many of us, when there are too many choices, confusion sets in and that leads to inaction. Not because we don't want to take action, but because we don't know what action to take.
For now, we're going to take two of the most popular ways to invest in the stock market: mutual funds and stocks (also known as "equities"). We'll keep the mumbo jumbo out of the mix and stick to the basics so hopefully you'll have enough comprehensible information to take the action which best suits your (and your family's) investment needs.
First Things First
Definitions. What is a mutual fund and what is a stock?
Think of a mutual fund as a group of people (investors) pooling their money and having a financial professional manage and invest that money into different securities, such as stocks and bonds.
With a mutual fund, your investment is more "diversified" because the fund is made up of a portfolio of multiple investments in order to reduce risk. So, if one of the securities/companies within that fund loses value, it's possible the other one (or two... or three...) securities/companies within that fund will gain value thereby helping to maintain one's initial investment. Then, when dividends (scheduled payments to fundholders) are distributed, you can reinvest them to add more value to your investment.
Now, think of a stock as shares in the ownership of a company. You are in charge of how many shares you own, when you purchase them and when you sell them. The more shares you acquire, the more ownership you have in the company.
When you purchase shares of a company, you're investing in only that one company. If the price of the stock rises, so does the value of your shares and so do your profits (if you sell shares). However, if the price of the stock falls, the opposite holds true - your investment loses value and if the price falls below the price you paid for the shares, you might even end up in the red. The value of your investment is based solely on the performance of one company. As with some mutual funds, many stocks offer dividends. Reinvesting those dividends is another way of increasing your ownership in that company.
Which is right for you?
So how do you choose the best investment tool for you? The objective of investing in a mutual fund or a stock is typically the same: profit and/or building of capital. It's primarily the investor's stock market experience and timeline that differ.
For investors who are new to investing and don't have the time to research hundreds of stocks, MUTUAL FUNDS can be a good way to go.
Peace of mind having a professional manage your investment
No need to research/analyze all available stocks
Diversification in times of market volatility
Capital gains (fund managers may sell a security and make a profit, however, even if the fund has a losing year, you still pay capital gains.)
For investors who are a bit more experienced with the financial market and also have the time to thoroughly research companies, investing in STOCKS might be the best choice.
Own a piece of a company you believe in
Higher profit if company does well
You choose when you want to buy and sell
Higher risk due to no diversification
Requires time and discipline to find the "right" stock
Need greater initial investment to buy a broad spectrum of stocks in order to be diversified.
Age is another important factor when deciding how to invest in the stock market. The younger the investor, the more time he or she has before reaching retirement. In essence, that means the younger investor can take a bit more risk (stocks) than an investor who is closer to retirement (bonds and mutual funds). Logic would say that this means the older investor should not invest in stocks, but that's not always the case. There are many strong, solid companies that pay high dividends - money that a retired person can use to help pay bills and enjoy vacations.
In the end, it's important to keep an eye on management fees, commissions and taxation ramifications that could eat into your profits. Once you've found a stock or mutual fund that you're comfortable with, ask yourself if you feel it suits your short- or long-term financial objectives. If the answer is "yes" - congratulations! You're on the road to becoming your own financial advisor.
*Before investing in the market, invest in yourself - check out our FICO Forum and see what other myFICO members are saying about personal finance. *