Stocks and mutual funds are popular securities for amateur and expert investors alike. Together they make up the bulk of a typical, well-diversified portfolio.
Stock is fairly straightforward: It represents shares of ownership of a public company. You can buy shares directly through a brokerage. If you buy a share of Apple, for instance, you’re technically part owner of that company.
Mutual funds are a little more complex, however, as they represent groups of securities packaged together. There are several types of mutual funds. Index funds, for instance, track a benchmark index like the S&P 500 or the Dow Jones Industrial Average. ETFs also track indexes, but they’re traded throughout the day like stocks. There are also actively managed funds which are guided by professional managers, and even funds-of-funds that group multiple mutual funds together.
(Here at Wealthsimple, we’re big believers in ETFs. While professional managers claim to beat the market, the truth is that they rarely do, especially once you account for their fees. ETFs are the right combination of affordability, diversification, and healthy returns.)
Are stocks and mutual funds right for your portfolio? First you need to understand these two types of securities: how they relate and how they differ.
Similarities Between Mutual Funds and Stocks
Stocks and mutual funds are key tools to invest your savings and grow your nest egg. Once you establish an emergency fund, you’ll want to stash as much as you can in a portfolio that includes both of these securities.
Both stocks and mutual funds represent your share of ownership. You can sell that ownership on the market. If you hold them long enough, there’s a good chance their value will increase and you can earn a profit. For this reason, many people buy and hold stocks and mutual funds for years—even decades.
When it comes to buying and selling securities, stocks and some mutual funds (like ETFs) can be purchased on the open market. You can grab them through your favorite brokerage.
Historically, both types of investment have produced healthy returns for investors. Even though past performance does guarantee future results, it’s reasonable to assume that stocks and mutual funds will continue to provide attractive returns for retail investors like you.
If you want ongoing fixed income, you can find stocks and mutual funds that pay dividends. You can withdraw your dividends for cash or reinvest them into your portfolio for compounding returns.
Differences Between Mutual Funds and Stocks
When you purchase stock, you own shares of a publicly traded company. If the company pays dividends, you can earn consistent income over time just by owning their stock. You can also sell those shares for more or less than your purchase price (though hopefully more!).
So if you own a stock, you own a portion of a single company. You can build your own portfolio with complete control by picking and choosing to invest in specific companies. Depending on the type of stock you own, you may be able to vote on shareholder matters.
Mutual funds are groups of stocks or bonds packaged together. The fund pools investor money together and uses it to buy and sell stocks, bonds, and other securities. So when you buy into a mutual fund, you own a share of the fund. This means you can invest a large number of stocks and bonds with a single transaction.
Mutual funds usually don’t have the same growth potential as stocks. A mutual fund won’t explode over night because of a popular new product, expansion into a new vertical, or a healthy earnings report. Even if one of the companies in your fund has a good year, its success will only represent a small portion of your investments. Essentially, the fund’s success is an average of the success of the all of the securities it owns.
Unlike stocks, however, mutual funds come with built-in diversification to minimize risk. Since you technically own pieces of many companies, the performance of an individual company doesn’t matter as much. You won’t lose your entire nest egg just because one company has a bad year.
Furthermore, buying stocks leaves all of the responsibility on your plate. It’s your job to research good buys and decide when to make your purchase. Mutual funds, however, let you take a more passive role because they are either managed by a professional or track a benchmark (e.g. if you buy a fund that tracks the S&P 500, the fund would purchase all 500 stocks on that list).
Pros and Cons of Mutual Funds and Stocks
Now that you understand how mutual funds and stocks compare to one another, let’s talk about whether they’re right for you. Here are the pros and cons of mutual funds and stocks.
Pros of Individual Stocks
They are highly liquid. Since mutual funds (of all kinds) buy stocks every day, it’s usually easy to sell off stock if you need cash for something else. Your only cost is a small transaction fee.
There aren’t any ongoing fees. Unlike funds, buying stocks doesn’t involve a manager. You’ll pay a one-time brokerage fee when you buy and sell, but no one takes a percentage of your earnings. The stock’s earnings go straight into your pocket.
You have complete control over your portfolio. Since you make every decision, you aren’t stuck with under-performing companies or businesses who don’t suit your goals. You can buy and sell any company at any time.
Cons of Individual Stocks
Finding good companies is challenging. Stock research is an ambitious and complex process that requires years of experience and hours of study. It’s hard to understand if a stock is undervalued or if it will grow. It’s possible to make money trading stocks, but you’ll have to focus on it full time. You’ll need a cash pool to trade with, too, which is why many professional traders start their own private, actively managed funds.
You’ll pay commissions to trade. You’ll have to pay a fee to a brokerage any time you want to buy or sell a stock. This can get expensive if you like to trade often.
It’s difficult to diversify. Good diversification means owning lots of different kinds of securities. That’s hard to achieve when you buy individual stocks, unless you’re willing to make hundreds of individual purchases. Mutual funds come with diversification built-in because each fund owns many securities.
Pros of Mutual Funds
Most come with professional management. Actively managed funds have professional investors who study the markets and invest your money accordingly. On the other end of the spectrum, index funds have investors who simply match the fund’s portfolio to whichever index they track. But in either case, there’s someone smart watching over.
Some have low fees. Actively managed funds can be expensive, but index funds are ETFs generally have low ongoing fees because there isn’t much for the fund managers to do. This is especially true if you use automated investing.
They come with easy diversification. Mutual funds own small pieces of many securities, which drives down your risk and protects your money. One company’s poor performance won’t cripple your portfolio.
Low time commitment. You don’t have to do anything once you purchase a mutual fund. No research, managing, buying, or selling. Just sit back and let it grow. It’s not unusual for people to hold on to the same mutual funds for years.
Cons of Mutual Funds
Most have minimum investments. You’d be hard pressed to find a fund that didn’t require at least a $1,000 buy-in, but many require more. Some actively managed funds require millions of dollars just to get in.
You don’t have any control over what the fund buys. Mutual funds usually have a broad investing philosophy. A fund might track an index or invest in a specific sector. But ultimately, you don’t have any way to influence what the fund buys and sells. If you don’t like what the fund owns, your only recourse is to sell your portion of the fund.
You can only trade once per day after the market closes. If you want to play with high frequency trading, you’ll need to use stocks, not mutual funds. (EFTs are the exception here. They are traded like stocks with fees for buying and selling.)
Mutual funds come with annual expenses. Even the most passively managed funds come with fees. Some managers will take entire percentage points off whatever the fund earns. So if a fund increases by 3.5% in a year, you may only make 2% after they subtract fees. The kinds of funds we work with at Wealthsimple—ETFs—come with low fees.
Verdict: Mutual Funds vs Stocks
As you can see, neither security is better than the other. They each have advantages and drawbacks. Choose the ones that make the most sense for your portfolio. Don’t forget to routinely check fees, rebalance your portfolio, and keep an eye on your risk.
If that still sounds like too much for you, you’re the right kind of person to use a robo-advisor like Wealthsimple. We’ll manage your portfolio and invest you in carefully chosen ETFs for your specific situation. We’ll rebalance your account to maximize diversification and minimize risk.
