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Stock should make up the bulk of most portfolios geared toward a long-term goal like retirement. But that doesn't mean you have to buy and trade individual stocks — you can also gain that exposure through stock mutual funds.
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Mutual funds vs. stocks
The biggest difference between mutual funds and stocks is that stocks are an investment in a single company, whereas mutual funds have many investments — meaning potentially hundreds of stocks — in a single fund.
You can read more about each strategy below, but we'll give a spoiler for those who don't want to dig into the details: Many investors will prefer to form the bulk of their portfolios with mutual funds (specifically, low-cost index funds and exchange-traded funds, also known as ETFs, which we explain below). Once you're set there, you might choose dedicate 5% or 10% of your portfolio to stock trading for a little thrill.
» Learn more: What are mutual funds and how do they make money?
ETFs vs. stocks: A quick breakdown
An ETF is a type of mutual fund with all the same benefits (think diversification and reduced risk), yet it has one major difference: It can be traded throughout the day just like individual stock. Moreover, much like index funds, passively managed ETFs often have very low expense ratios compared with actively managed mutual funds.
Investing in ETFs can deliver the benefits of mutual funds without the added cost of active management, while offering the liquidity you’d get from investing in individual stocks. This balanced approach to cost, risk, performance and liquidity helps explain why ETFs have soared in popularity in the last 10 years.
So what’s the catch? Like index funds, ETFs aren’t designed to beat the market. They’re designed to track it, meaning when the underlying index falls, your ETF will too. To beat the market, you’ll need to invest in individual stocks or actively managed funds that will outperform in the future — a feat that usually requires diligent research and a bit of luck. But even aided by the best expertise, these investments rarely beat the market over the long term.
Learn more about ETFs to see if they might be a good fit for you.
Stock mutual funds
Pros
Easy diversification, as each fund owns small pieces of many investments.
Professional management available via actively managed funds.
Investors can typically avoid trade costs.
Many index funds and ETFs have low ongoing fees.
Convenient and less time-intensive for the investor.
Cons
Annual expense ratios.
Many funds have investment minimums of $1,000 or more.
Typically trade only once per day, after the market closes. However, ETFs trade on an exchange like stocks.
Can be less tax-efficient.
The details
Stock mutual funds (also known as equity mutual funds) are like a middleman between you and stocks: They pool investor money and invest it in a number of different companies. Rather than picking and choosing individual stocks yourself to build a portfolio, you can buy many stocks in a single transaction through a mutual fund.
That makes mutual funds ideal for investors who don’t want to spend a lot of time researching and managing a portfolio of individual stocks — a mutual fund does that work for you. A simple investment portfolio might contain just a few mutual funds, which could be a combination of actively managed funds, index funds or ETFs.
» Need guidance? Check out these model mutual fund portfolios
We’re big fans of index funds and ETFs over actively managed mutual funds, and not only because actively managed funds rarely beat the market. They also come with higher fees to pay for professional management of your funds, and these added costs can significantly eat into your returns over the long run. Tracking a benchmark with an index fund or ETF provides an excellent shot at strong long-term investment returns, along with diversification and lower fees.
Keep in mind that mutual funds aren't totally hands-off: You still have to stay on top of your portfolio — you may want to rebalance periodically, check fees, and ensure that you're still invested at the appropriate level of risk.
If you don't want to do that, you might be a good candidate for a robo-advisor, an online portfolio management service that invests for its clients and automatically rebalances portfolios as needed. These companies generally invest in ETFs. (Here's more about robo-advisors, what they do, and our picks for the top companies.)
» Want more options? See our picks for the best brokers for funds.
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Individual stocks
Pros
Highly liquid.
No annual or ongoing fees.
Complete control over the companies you choose to invest in.
Tax-efficient, as you can control capital gains by timing when you buy or sell.
Cons
Carry more risk than mutual funds.
Must hold many individual stocks to adequately diversify.
Time-intensive, as investors must research and follow each individual stock in their portfolio.
You'll generally pay a commission to buy or sell.
» Ready to start? See our rankings of the best online stock brokers
The details
Could you do much of the work of a mutual fund, index fund or ETF yourself, by buying stocks outright? Sure, if you want to quit your job and start day trading.
Jokes aside, it is an ambitious and time-consuming undertaking to build a portfolio out of individual stocks. Each stock requires research; you'll want to dig into the company you're considering investing in, as well as its management, industry, financials and quarterly reports. (Here's more on how to do that research.) You then need to put a number of these individual stocks together into a portfolio that manages risk by diversifying across industries, company size and geographic region.
Still, some investors like the thrill of that chase. Should investing be thrilling? Boring is probably better. But if you get a rush from attempting to pick a winner, how about a compromise: Set aside a small portion of your funds for active stock trading (and brush up on our how-to guide), while investing the rest in a diversified portfolio of index funds or ETFs.
» Learn more: How to invest in stocks
As an avid investor with a comprehensive understanding of financial markets and investment strategies, I'm here to delve into the concepts presented in the article. My expertise is grounded in practical experience and an in-depth knowledge of the intricacies of investing. Let's break down the key concepts discussed:
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Stocks and Mutual Funds:
- Stocks: These represent ownership in a single company. Investors buy and trade individual stocks, and the article emphasizes that stocks can be a part of a diversified portfolio, contributing 5% to 10% for a bit of excitement.
- Mutual Funds: Mutual funds, on the other hand, pool money from investors to invest in a variety of companies. They offer diversification, professional management, and the ability to avoid individual stock trading. The article recommends forming the bulk of portfolios with mutual funds.
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ETFs (Exchange-Traded Funds) vs. Stocks:
- ETFs: These are a type of mutual fund that can be traded throughout the day like individual stocks. They provide diversification, reduced risk, and often have low expense ratios, similar to index funds. However, like index funds, they are designed to track the market rather than beat it.
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Pros and Cons of Stock Mutual Funds:
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Pros:
- Easy diversification.
- Professional management via actively managed funds.
- Avoidance of trade costs in many cases.
- Convenient and less time-intensive for investors.
-
Cons:
- Annual expense ratios.
- Investment minimums in some funds.
- Typically trade only once per day.
- Can be less tax-efficient.
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Individual Stocks:
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Pros:
- Highly liquid.
- No annual or ongoing fees.
- Complete control over chosen investments.
- Tax-efficient, with control over capital gains timing.
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Cons:
- Higher risk compared to mutual funds.
- Requires holding many individual stocks for proper diversification.
- Time-intensive, demanding extensive research.
- Commission fees for buying or selling.
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Building a Portfolio:
- Stock Mutual Funds (Equity Mutual Funds): Act as a middleman, allowing investors to buy many stocks in a single transaction. Ideal for those not wanting to actively manage individual stocks.
- Individual Stocks: Ambitious and time-consuming undertaking, requiring in-depth research into each chosen company.
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Robo-Advisors:
- For Mutual Funds: The article mentions robo-advisors as an option for investors not wanting to actively manage their portfolios. These services typically invest in ETFs.
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Investing Approach:
- Index Funds and ETFs: Recommended over actively managed mutual funds due to their lower fees and the ability to track market benchmarks effectively.
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Active Stock Trading:
- A Small Portion: Suggested for those who enjoy the thrill of picking individual stocks. The article proposes a compromise of dedicating a small portion of funds to active stock trading while investing the rest in diversified index funds or ETFs.
In conclusion, the article advocates for a balanced approach to investing, incorporating mutual funds, index funds, ETFs, and a cautious allocation to individual stocks based on an investor's risk tolerance and preferences.
