Every investor is usually faced with two main options: Mutual Funds or Individual Stocks. Mutual funds are actively managed group of stocks, usually designed to beat the market with the assistance of a fund manager. Individual stocks can be bought by any investor through a brokerage, and it becomes the responsibility of the individual investor to maintain his/her portfolio. Mutual Funds are widely regarded as a passive form of investing while investing in individual stocks is more of active form. Though both carry inherent advantages they do also have risks associated with them, it is therefore paramount for investors to understand the differences between them.
Mutual funds appeal to most beginner investors since they are automatically diversified, presenting the investors with a large variety of flavors from sector based funds such as Tech, Financial, Retail, Energy , Commodities to Foreign indexes. Mutual Funds generally hold a large number of stocks with each equity only comprising a small percentage of the portfolio. This is both its strength and weakness.
Let look at an example, a Tech Mutual Fund may claim Microsoft as one its top holdings, but a rally in Microsoft shares may barely move the mutual fund, on account of Microsoft only comprising 1.5% of the overall portfolio, and the remaining 98.5 % being composed of industry Laggards such as Cisco. However, a crash in Microsoft shares will also be cushioned by its low portfolio weight and buffered by other less volatile stocks. Even though the growth of mutual funds may be limited, the downside is limited as well.
Key points to note when dealing with mutual Funds:
- Investors don’t define the exact number of shares to purchase, but rather they will order a set dollar amount from a brokerage, and the brokerage will calculate the shares to be bought based on the day’s closing price.
- The share price of a mutual fund doesn’t fluctuate during the day, it is only reported after the market close based on the closing prices of its underlying securities.
- Investors who may be interested in actively trading mutual funds should invest in Exchange Traded Funds (ETFs).
- Each mutual fund has its own set of fees and expenses, these can include: The fund manager’s fee, front-end load upon initial purchase, a back-end load upon sale, as well as early redemption charges.
- Index funds, which are passively managed Mutual funds are a lower-cost alternative option if the investor wants to avoid the fees associated with actively managed Mutual funds. Index funds simply mirror a set market index e.g. the S&P 500.
- Mutual funds investors should allow a longer time frame to observe the slow and steady growth. They should invest regularly hence taking advantage of dollar cost averaging i.e. purchasing more shares when the price is low and fewer shares when the price is higher. You can also use automatic dividend reinvestment plan to reinvest your dividends into the fund hence sidestepping the capital gains tax on cash dividends and brokerage commission charged for purchasing additional shares.
Individual stocks usually bring in more returns as compared to mutual funds.
Key Points when dealing with Individual Stocks:
- Purchasing can be done directly through any brokerage, with the only fees being the commission paid upon the purchase of shares and the capital gains tax paid upon the sale.
- Investors define exactly the amount of shares to purchase, and the desired price.
- Dividends from the stocks can be reinvested into the company.
- Investing in a single company can be a high risk, high reward affair. To offset this risk, most investors will choose a small basket of stocks to counterbalance each other to diversify and minimize risk.
Generally, investing in individual stocks requires more work on part of the investor in terms of studying the market terminology, assessing the current state of their portfolios, paying attention to quarterly earnings, commodity prices, interest rates etc.
Individual stocks are more involving emotional affair as compared to Mutual funds but either way each has its own merits and demerits. If you aren’t sure which investment to choose, it is advisable to involve the services of a Financial advisor or Investment advisor.
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