Mutual funds vs. stocks: which is the better investment?

The primary goal of any investment is to achieve higher returns with as little risk exposure as possible. When comparing mutual funds vs stocks, the returns don’t necessarily determine which type of investment is better. They can both potentially deliver supernormal returns, and it goes without saying that they both have their pros and cons. The goal is to find a convenient investment that offers consistent above-market returns with as limited risk exposure as possible.

So, the question is, what’s the difference between mutual funds and stocks, and more importantly, which is the better investment? 

Mutual funds vs stocks

When you buy a share in a company, you receive legal ownership of the company, with voting rights. This entitles you to a share of the company profits – which you’ll receive as dividends. For a shareholder, earnings are in the form of dividends or the sale of shares.

A mutual fund, on the other hand, is an investment vehicle that pools capital from different investors to invest in various securities in the capital market like bonds, stocks, and other financial securities. In this case, the investors of a mutual fund are considered the shareholders in that fund. Consequently, the profits from these investments are then distributed to the investors on a prorated basis. 

Investors can earn returns from dividends paid on the securities the fund holds, from capital gains when the fund liquidates, or by selling their share in the fund. The value of a mutual fund will depend on the market performance of the securities it invests in. Note that these investments are structured and managed by professional fund managers.

With that in mind, let’s discuss the types of mutual funds.

Types of mutual funds

Broadly, mutual funds are categorised as equity funds, fixed-income (bonds) funds, money market funds (short-term debt), Index funds, target date funds, or asset allocation funds (both stocks and bonds). 

Mutual funds can also be as exotic as the fund manager may want. These are called specialty mutual funds. Such funds are designed to attain investment objectives by utilising non-traditional trading strategies and assets. These may include investing in commodities (commodities funds), focusing on a specific sector (sector funds), a particular geographical region (regional funds), investing in other mutual funds (funds of funds), or investing according to some specific environmental or social governance guidelines (ESG funds).

Note that these funds can be actively managed by portfolio managers or they can be index funds, designed to mimic the performance of a specific index. Always read through the mutual funds’ prospectus to fully understand what the fund invests in, and its investment target.

Mutual funds vs. stocks: which is the better investment?

Now that we understand the difference between mutual funds and stocks, let’s discuss which one is the better investment.

By most metrics, mutual funds are the better investment. Here’s why;

1. They are sufficiently diversified across industries and geo locations, 
2. They are run by professional financial managers
3. They offer various investment strategies 

However, in any form of investment, there are three main aspects to consider – risk, cost, and returns. Let’s see how stocks and mutual funds compare.

Risk and diversification

Ideally, buying a stock could be a good way to focus your capital on a single company and potentially benefit from its growth. However, this comes at a considerable risk of being wiped out if the company goes under.

To be adequately diversified when investing in stocks, you’d probably need to buy multiple stocks from various industries. But this would require extensive research on each stock and industry, which is cumbersome! Not to mention you’ll have to constantly monitor each of these stocks separately. 

This is why mutual funds are the most convenient. The most significant mutual funds advantages are investment diversification. A single mutual fund is adequately diversified to withstand systemic risks. The fund managers can also use various investment strategies to ensure the mutual fund remains profitable even in a prolonged bear market. More so, with mutual funds, you pass on the burden of investment research, management, and monitoring to the fund managers. All you need to do is just find the best mutual funds to invest in.

Returns

Mutual funds’ returns largely depend on the macroeconomic environment. Fund managers usually implement strategies to ensure regular and stable returns. They can adjust the fund’s composition over time to achieve the target returns. More so, no single security in the fund can adversely impact the overall returns.

For stocks, the returns generated entirely depend on a company’s financial health, the overall economy, and the state of the industry it operates in. Generally, stocks have the potential for supernormal returns, but that potential comes with the danger of systemic risks. 

And although actively managed mutual funds often offer higher returns than investing in stocks, past performance isn’t always indicative of future results. So, when choosing a mutual fund, consider how long the fund has existed, the duration the current fund managers have been with the fund, its volatility, and if the investment strategies employed have been consistent over the life of the fund.

Cost

The only cost associated with stock investments includes the transaction fees when buying and selling the shares – the brokerage commissions. 

The fees associated with mutual funds vary from one fund to another. Some funds charge a fee when you buy in, and others upon exit – and they vary. Investors also have to pay an expense ratio, for actively managed funds, which is justifiable if the manager can deliver superior returns. Some mutual funds are no-load funds which means that investors don’t incur any commissions. 

Taxation

For stocks, investors are only liable for capital gain taxes when they sell off their shares. For mutual funds, investors are liable for taxation even if they continue to hold the fund. That’s because most actively managed mutual funds buy and sell stocks throughout the year. 

Even if the overall value of the mutual fund drops, investors will still incur capital gains taxes for the sales made by the fund during the year. Index funds are more tax efficient since they rarely buy and sell stocks. When choosing an actively managed mutual fund to invest in, its turnover ratio provides a good measure of its tax efficiency. Turnover measures the duration a mutual fund holds a stock before it sells.

How to invest in mutual funds

If you intend to invest in mutual funds, you can do so online through investment companies BlackRock or JP Morgan. You can also invest in mutual funds through financial services companies like Vanguard and Fidelity Group, or online brokerages. They all offer several tools and products to help investors select mutual funds.

When choosing a mutual fund, there are three main things to consider. Firstly, what are your investment goals? Secondly, consider the expenses involved – this will most likely determine whether you choose actively managed mutual funds or index funds.  And thirdly, keep taxes in mind. 

The bottom line

Compared to stocks, mutual funds are diversified limiting risk exposure in the financial market. Investing in stocks gives you exposure to the performance of one company. And although you can potentially receive supernormal returns, the downside is that you are exposed to systemic risks. With mutual funds, you are effectively investing in multiple securities, across different industries, and geographical locations. Your investment is adequately diversified to withstand any systemic risks, and no single security can adversely impact your potential returns. 

But at the end of the day, you should invest in an asset based on your financial goals, and risk profile. There are instances where one may prefer to gain exposure to a single stock. But it’s always better to diversify.