There are three primary ways to invest in the stock market; mutual funds, exchange traded funds (ETFs) and individual stocks. With mutual funds and ETFs your money is pooled together with money from other investors and is professionally managed in accordance with a predefined objective. Some major benefits of investing in mutual funds and ETFs include diversification, professional management and time savings. Some disadvantages of mutual funds may include management fees and less control on when gains become taxable.
An essential factor in effectively managing your portfolio is diversification and it’s difficult to maintain a diversified portfolio without investing a significant amount of money. A diversified portfolio should be comprised of a combination of fixed income investments and stock market based investments. The stock based investments should be comprised of small, medium and large companies in a variety of different industries in both the United States and abroad. Investing in a wide variety of companies and industries can spread out your risk. Mutual funds allow you to easily diversify your portfolio by pooling your funds with those of other investors. Instead of buying 10 individual stocks you can by 5 to 10 mutual funds in different areas of the market, each of which may contain hundreds of companies.
Although managing your finances should be a priority, most investors lead busy lives and don’t have the time to research and monitor individual stocks. Mutual funds can be a good alternative to doing your own research. Most mutual fund companies have entire teams of highly skilled analysts who visit companies, analyze data, assess the competition and monitor industry trends. It would be difficult to attain this level of knowledge and understanding on your own. Additionally, professional management provides the methodology and discipline to keep emotions out of investment decisions. When investing in individual stock, investors can become emotionally attached to a company whose stock has performed well. This can result in dangerously high concentrations in a few individual companies.
Mutual funds and ETFs use a broad approach that generally tracks more closely to the entire stock market or a specific index. Individual stocks, on the other hand, can provide the opportunity to break away from market performance to make a significant profit, if you select a winner. However, you many also experience a significant loss if the stock is a loser.
Some potential disadvantages of mutual funds in comparison to individual stocks include management fees and less control over when you pay capital gains tax, within non-retirement accounts. With individual stocks and ETFs you don’t pay capital gains until you sell your shares. However, when a mutual fund manager sells stock within a fund, gains earned on the stock are passed through to the shareholder as a taxable gain. This gain is added to the investor’s basis in the mutual fund to avoid double taxation when the fund is eventually sold.