Individual Stocks or Mutual Funds?

If you want to invest and grow your money, you have many choices. You can play in the stock market and invest in stocks, picking and choosing like Warren Buffett or a $20 billion hedge fund manager. Or, you can go with mutual funds, choosing to spread yourself out a bit and diversify. There are also bonds, commodities, and currencies.

For the most part, though, stocks and mutual funds are the most popular tradable asset classes in the market. For this reason, investors sometimes have problems determining if they should invest in individual stocks or go with mutual funds.

Here, I’ll provide you with a guide so you can make an informed choice about what assets you should include in your portfolio.

A Brief Guide to Mutual Funds

Understanding individual stocks is pretty straightforward; it’s the notion of a mutual fund that gives some investors problems.

A mutual fund is a collection of stocks, essentially. A fund consists of investment capital from many different investors pooled together. The capital that is pooled together is then used by a professional called a fund manager who chooses which stocks to purchase. Of course, you can have a mutual fund that trades in another asset class, like bonds (for example, you can have a government bond mutual fund), but here we’ll stick to the stock variety.

Advantages of Mutual Funds

Why do investors turn to mutual funds? What is their purpose? There are several reasons.

First, a mutual fund offers risk mitigation, also known as diversification. When you diversify your investments, you are spreading out your risk instead of putting all of your eggs in one basket. For example, you can buy a mutual fund that has 50 stocks in it, spread out across five different sectors. If one sector tanks in the market, you’re okay – the other four can make up for it.

General consensus states that you need at least 20 stocks across different industries and sectors for adequate diversification. Then, the main risk is systemic; in other words, you’ll suffer if the market itself takes a nose-dive. Otherwise, you’ll break even or profit more often than note.

The second reason people choose mutual funds is to incorporate different trading strategies into one portfolio. For example, two competing strategies are growth investing and value investing. Growth investing chooses stocks that are high performers, stocks that earn more than the industry average and grow rapidly. Value investing chooses stocks that are under-priced and undervalued, or “cheap”. With a mutual fund, you can actually make use of both strategies at the same time.

The third reason people choose mutual funds is to lower purchasing costs. If you wanted market exposure in, say, five different sectors, you’d have to buy stock in companies in each of these sectors. Let’s say you want four stocks per sectors, to arrive at the magic number of 20 stocks in your portfolio. At a minimum share size of 100 (the standard for most brokerages), you’d be looking at 2,000 shares total.

If the average share price is $10, that’s a total investment of $20,000 for a diversified portfolio. The average price probably won’t be that low, though; a more realistic bet is, say, $25, for a total investment of $45,000.

What if you could just buy shares of a mutual fund that had your 20 desired stocks? You’d pay less, for starters. Let’s look at a real fund for comparison. The Alger Capital Appreciation Fund (ACAAX)contains 126 stocks and cost $15.88 as of July 6, 2012. For $45,000, you could get 2,833 fully-diversified shares.

Advantages of Individual Stocks

Of course, there are advantages to buying individual stocks, too.

Buying individual stocks gives you control and precision. You get to choose exactly what stocks you want to buy, how many shares you want, and how long you want to hold them. With a mutual fund, those decisions are out of your hands.

Also, with stocks, you can avoid fund management fees and expenses that can be expensive. Online discount brokerages with low trade commissions or fees are abundant. TradeKing, for example, has trades that cost just $4.95 – which is absurdly low when you consider the fact that professional brokers charge either flat-rate fees or commission that can be in the hundreds of dollars.

Which Should You Choose?

Really, the choice comes down to individual preference. If you want to mitigate risk, place investment decisions like buying and selling stock in the hands of a professional, diversify easily and inexpensively, and take advantage of using more than one style in a single asset, mutual funds may be for you.

On the other hand, if you want to be more aggressive, want total control over your investments, and would prefer to avoid paying a professional manager 1-2% per year, individual stocks may be for you.

Of course, there’s nothing to say that you can’t have both, if you have enough investment capital. Talk to your financial advisor to see what he or she says for your specific circumstances.

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