Mutual funds are a better option than individual stocks for most investors. The decision to invest in mutual funds or individual stocks depends on the size of your portfolio, your investment knowledge, your level of time and involvement, your risk tolerance, your ability to make objective investment decisions and your tax situation.
Many investors don’t have enough money to adequately diversify their portfolio across a wide range of individual stocks. To gain true stock diversification, you need to invest in companies of different sizes, in a wide range of different industry sectors and in a variety of different geographies. Mutual funds enable you to gain this broad diversification by pooling your money with a large number of other investors.
Additionally, mutual funds are professionally managed, making them ideal for individuals with limited investment knowledge or a limited amount of time to research and monitor individual stocks. Most mutual fund companies have a large staff of managers and research analysts who analyze financial reports, visit companies and keep tabs on the economic and political climate. It is very difficult for most investors to devote the time and commitment needed to create and maintain a well-diversified portfolio of individual stocks.
Professional managers also have access to more timely information. Many investors are tempted to buy and sell individual stock based on current events. However, the market is relatively efficient which means it quickly responds to new information. What seems like breaking news has probably already been factored into the price of the stock.
Unfortunately, diversification and professional management does not come without a cost. Most mutual funds charge an annual management fee of between .25 and 1.25%.
Additionally, when investing your own money it is hard to stay objective. We have a natural inclination to emotionally react to changes in the market and to become emotionally attached to specific stocks. It is easier for mutual fund managers to make objective decisions. Performance is usually better when we stay on course and history shows us that investors in individual stocks trade more frequently than mutual fund investors.
Mutual funds can also be a better option for investors who are risk adverse. By investing in a broadly diversified portfolio of mutual funds, most of your risk will come from fluctuations in the market. A portfolio comprised of several individual stocks is generally more volatile. It also carries a higher risk of losing money if a company, whose stock you own, has financial problems or goes out of business.
A disadvantage to owning mutual funds, instead of individual stocks can be a lack of control on when you pay capital gains. This is especially true if you are in a high tax bracket and a lot of your money is invested outside of retirement accounts. When fund managers sell stock, gains must flow through to the investors as they are earned, not when the fund is sole.