Mutual funds are investment vehicles that pool money from multiple investors to buy a diversified portfolio, while stocks represent ownership in a specific company and their value fluctuates based on the company's performance and market conditions.
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Key Takeaways
Mutual funds diversify investments, reducing risk, but also limit potential gains.
Mutual funds are managed by professionals, reducing the need for monitoring, but investors give up control.
Stocks offer higher returns but come with higher risk and volatility.
Both mutual funds and stocks have fees and expenses that can affect investment returns.
The choice between mutual funds and individual stocks depends on an investor's goals, time horizon, and risk tolerance. A diversified portfolio may offer a good balance.
As a new investor, it's helpful to consider your investment choices, including the choice of mutual funds or stocks. Confused? Many new investors are.
What is the Difference Between Mutual Funds and Stocks?
When you invest in individual stocks, you're buying shares (the stock) of a single company. When you invest in a mutual fund, you're buying shares in a fund which invests in multiple securities such as:
Stocks
Bonds
Money market instruments
Other assets
Each mutual fund usually has an investment objective that states how the fund will invest.
This may be based around a number of things including:
An industry (financial, real estate, technology, healthcare, etc.)
A region (European, American, Asian or emerging markets)
An index.
People have different reasons for buying mutual funds vs. stocks. Someone could do both as part of their investment strategy.
Pros & Cons of Mutual Funds
Investing in mutual funds workfor those who want to participate in the stock market but don't necessarily want to pick and follow specific stocks. Owning "baskets" of stocks gives investors the advantages of being in the stock market and diversifying their investmentswhile saving them the trouble of picking their own stocks by letting financial pros do the picking or by using an automated index approach.1
Pros of Mutual Funds
Risk is spread out by investing in multiple companies as part of a diversified investment fund. It can be harder to do when picking individual stocks.
If an individual stock loses value, other stocks in the mutual fund help to balance it out.You haven't put all your eggs in one basket, however, all the stocks in a fund could lose value at the same time.
A financial professional chooses which stocks go into the fund and then manages it. You don't have to closely monitor individual stocks.
If you're interested in a specific industry sector, you can invest it that sector without having to individually choose stocks.
Cons of Mutual Funds
If a single stock excels, you miss out on some of that high growth. You'll benefit from that growth if the stock is included in your mutual fund, but not to the same extent, as the stock will be diluted by the others in the fund.
Those who prefer greater control over their investments may not like giving away choice in stocks to a mutual fund's managers.
Some funds have minimum investment rules and require the fund be held for a certain amount of time before cashing out or you could be charged a fee if you cash out early. Mutual funds also charge a percentage of the investment as a management fee.
Pros & Cons of Stocks
Buying stocks can be a good choice for people who want to own specific stocks and are able to handle more potential volatility.
Pros of Stocks
You control what stocks you invest in.
If a stock soars, you'll get all the benefit from that increase. If you had that stock in a mutual fund, the benefit would be diluted by the other stocks in the fund, but also have to bear all the loss if that stock falls in value.
People might find it exciting and rewarding to pick and follow specific stocks.
Cons of Stocks
Stocks can be volatile. The highs and lows are emotionally difficult for some investors.
It can be time-consuming to monitor individual stocks. This isopposed to simply buying and holding a share in a mutual fund.
You could be charged a brokerage fee every time you buy or sell an individual stock.
The Bottom Line
If you haven't previously been investing in mutual funds or buying your own stocks, or new to investing, you could try each approach to see which you like best, as long as you keep the potential risks in mind. There are risks involved in both types, including the potential to lose the entire principal amount invested. Those who are new to investing might find it easier to invest in mutual funds.
Whatever you choose, your investments decisions should always be based on your individual goals, time horizon and risk tolerance.
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Footnotes
Diversification cannot guarantee a profit or protect against a loss in a declining market.
For many investors, it can make sense to use mutual funds for a long-term retirement portfolio, where diversification and reduced risk are important. For those hoping to capture value and potential growth, individual stocks offer a way to boost returns, but come with more volatility.
Mutual funds diversify investments, reducing risk, but also limit potential gains. Mutual funds are managed by professionals, reducing the need for monitoring, but investors give up control. Stocks offer higher returns but come with higher risk and volatility.
A good mutual fund will usually outperform the broader market, thanks to the winning bets in its portfolio. In recent times, the small- and mid-cap stocks have given spectacular returns. But don't invest in a company just because it is in a mutual fund's portfolio. You need to check the valuation before taking a call.
When investing in equity mutual funds, do it via systematic investment plans (SIPs). By investing a fixed amount at regular intervals, irrespective of prevalent market conditions, you reduce the risk factor further. When markets are down, you get more units, and when markets are up, you buy fewer units.
What is the average return of mutual funds? Historically average around 9% to 12% annually. Subject to market volatility but offer potential for higher returns. Can include subcategories like large-cap, mid-cap, and small-cap funds.
Mutual funds have several advantages over individual stock picking. Beyond diversifying your holdings, some mutual funds aim to outperform the stock market, while others mirror a popular index like the S&P 500.
However, mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high expense ratios charged by the fund, various hidden front-end and back-end load charges, lack of control over investment decisions, and diluted returns.
Mutual funds are cost-effective due to their low investment and management fees. Mutual funds have high liquidity, which means that investors can easily buy and sell units without any inconvenience.
Potential for loss: Mutual funds are not FDIC insured and may lose principal and fluctuate in value.
Cost: A mutual fund may incur sales charges either up-front or on the back end that are passed on to the investors. In addition, some mutual funds can have high management fees.
A widely accepted guideline is the 50/30/20 rule. Allocate 50% of your income to necessities, 30% to discretionary spending, and reserve 20% for savings and investments. Within this 20%, your mutual fund allocation can be further optimised based on your risk tolerance and investment goals.
For many investors, it can make sense to use mutual funds for a long-term retirement portfolio, where diversification and reduced risk are important. For those hoping to capture value and potential growth, individual stocks offer a way to boost returns, but come with more volatility.
The rule of thumb is five years. If it's a riskier type of fund, such as a small-cap one, then I would say, seven years. But a better approach would be to link your equity fund to a long-term goal, such as your retirement and children's higher education.
The chances of your mutual fund investment value going to zero are practically almost impossible as it would mean that all the assets in the fund's portfolio will have to lose their entire value. However, the returns from a fund can go to zero or even become negative.
Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.
In 2024 so far, infrastructure sector based funds have led the return chart and gave the highest return upto 48.33%. HDFC Defence Fund, the only active fund based on defence sector, gave 44.35% return. Invesco India Focused Fund gave 37.33% return in the same time period.
In this sense, mutual funds are seen as a 'safer' bet in comparison to equity stocks, due to their low risk quotient. Returns - While mutual funds offer investors very decent returns over a period of time, equity stocks have the potential to bring the investor extremely high returns over a much shorter period of time.
ETFs generally have lower expense ratios, better liquidity, and are more tax-efficient compared to mutual funds. On the other hand, mutual funds offer more diversification options and the potential for active management to outperform the market.
There are thousands of mutual funds available, and their risks vary widely from blue-chip conservative to highly speculative. A money market fund invests only in low-risk short-term debt such as Treasury bills. Money market funds value the safety of principal over the chance of high profits.
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