Stocks vs Mutual Funds
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Stocks vs mutual funds represents a frequent and popular topic for debate among financial experts.
But did you know you don’t necessarily have to choose? In fact, the better strategy is to include both stocks and mutual funds in your portfolio as part of a balanced (diversified) long-term investing strategy.
And here is another wrinkle many people who are new to investing don’t think of – you can also invest in stocks through investing in mutual funds.
But before you can decide which assets and how much of each will make the most sense to your investing strategy, it sure helps to make sure you understand the similarities and differences, pros and cons of stocks vs mutual funds.
What Are Stocks?
Stocks are sometimes called equities, shares, securities, common or preferred, big cap, small cap, fractional or penny – but what do all these terms mean?
At the most fundamental level, a stock is simply a share of ownership. But the ownership is not in the company itself – the brick and mortar (or website infrastructure). Rather, what you own when you purchase a share of stock is a single share’s worth of that company’s profitability.
Stocks come in several flavors. The two major categories of stocks are preferred stocks and common stocks.
Preferred stocks are still equity, but they act more like bonds in that, technically, they represent a unit of debt rather than a share of ownership. Like bonds and other forms of debt, the value of a preferred stock share will move inversely with interest rates.
Because preferred stock shares qualities with both stocks and bonds, investors often call preferred stocks “hybrid securities.”
So how might this work if you decide to invest in preferred stock?
When you purchase a share of preferred stock, you are essentially extending a micro line of credit to the issuing company. In return, like any other loan repayment, you will receive fixed dividends that will arrive at regular pre-set intervals so long as the company remains sufficiently profitable to pay those dividends.
The value of a share of preferred stock will still fluctuate based on market volatility, but the degree of fluctuation will be minor when compared with common stock.
You give up voting rights for the sake of more reliable returns and certain other benefits that may vary depending on the issuer.
Preferred stocks are arguably a less risky type of stocks for diversification purposes, since you have some protection against market volatility and potential company liquidation. However, if a company loses money in a given year or goes belly up, there is still a risk preferred stock holders will not be paid. In this case, preferred stock holders stand in line for repayment before common stock holders but after bond holders.
Institutions often invest in preferred stock because this investment can decrease year-end taxable income by up to 70 percent. This perk is not available to individual investors.
Common stocks are the workhorses of the equity world.
Not only are there many more shares of common stock available at any given time, but common stock confers voting rights and variable (fluctuating) dividends, which ramps up both the potential risk and the potential for reward.
Three Other Kinds of Stock You Should Know About
Up to this point, we have primarily been discussing a single category of stocks called big cap stocks. These are stock offerings by major companies, usually corporations with assets of $10+ billion.
There are four other kinds of stock you should at least be familiar with before you dive into building your portfolio. These four types of stock are fractional shares, small cap stocks, micro-cap/nano-cap stocks and penny stocks.
While this is less widely discussed, stocks can also be sold in the form of fractional shares. A fractional share is a percentage of a single share of stock.
Fractional shares can be useful for the sake of maintaining a fully invested (cash-free) portfolio.
Fractional shares are also worth mentioning here because this is essentially what you are purchasing when you buy a share of a stock mutual fund.
Small Cap Stocks
Small cap stocks are simply stock shares issued by smaller companies. Typically these companies have assets ranging in value from $300 million to $2 billion.
Small cap stocks can be issued by startup companies, but more commonly they are simply shares of smaller companies. As such, small cap stocks typically come with similar risks to big cap stocks and often the potential for greater returns.
Micro-Cap or Nano-Cap Stocks
Micro-cap stocks are issued by companies with assets ranging from $50 million to around $300 million. Nano-cap stocks are issued by companies with less than $50 million in assets.
Both micro-cap and nano-cap stocks can be more risky than small-cap or big-cap stocks for two reasons: the issuing company has less of a cushion against market volatility and internal losses and these stocks may not be registered through (and thus reviewed by) the U.S. Securities and Exchange Commission (SEC).
But some micro-cap and nano-cap stocks may represent a (relatively) stable and risk-balanced investment if the issuing company is essentially solid, has a good track record to date and is posting consistent growth.
While often the terms micro-cap, nano-cap and penny stocks are used interchangeably, there is actually an important difference between the three.
Penny stocks are stocks traded for five dollars or less per share. These tiny stocks are not tied to a minimum market valuation. They do not have to meet SEC rules and regulations. They tend to have very low liquidity and little history.
They are very, very risky.
Pros and Cons of Stocks
In this section, we give you the major pros and cons of stocks as an investment option.
Pros of stocks:
- Historically, stocks deliver a higher rate of return than other asset classes.
- No account or fund maintenance fees attached.
- Stocks allow you to build a portfolio tailored to your interests and priorities.
- Tax loss harvesting can help you adjust against capital gains at tax time.
Cons of stocks:
- Stocks carry a higher degree of risk than other asset classes due to market volatility.
- Achieving diversification with a true stocks-only portfolio is time-intensive.
- Stocks can still be expensive to trade due to buy/sell commissions.
- There is absolutely no guarantee of return and you may lose everything you’ve invested.
Best for risk-averse investing:
- Preferred stock
- Closed-ended stock
- Stock funds (mutual funds populated with stocks)
- Big cap or small cap stocks
Best for risk-tolerant investing:
- Common stock
- Open-ended stock
- Fractional shares (for a fully invested, no-cash portfolio)
- Micro-cap/nano-cap stocks or penny stocks
What Are Mutual Funds?
Now that we’ve looked at stocks from every angle, it is time to tackle our next question: what are mutual funds?
If you went trick-or-treating when you were young, you are already familiar with the basic concept of mutual funds.
When a lot of different people put a lot of different yet highly valued things together in a single bowl, what you basically have is a mutual fund.
So what is a mutual fund manager, then?
When you came home with your treat-filled candy basket, your folks probably picked through it all and told you what you could eat now or later or never.
Mutual fund managers perform essentially the same function for the funds they manage. Each mutual fund has a manager or team of managers who pick and choose among various investment assets and assemble what they believe is the most balanced and potentially profitable collection of assets that will make money for all involved.
Mutual funds can contain all same-type assets, such as solely stock-funded mutual funds. Mutual funds can also contain different-type assets, such as mutual funds that contain both stocks and bonds and other forms of short-term debt.
There are two main types of mutual funds: open-ended and closed-ended.
Open Ended Mutual Funds
Just like common stock makes up a far greater percentage of the stock trading marketplace, so too do open ended mutual funds far outpace closed ended mutual funds in terms of trading volume.
When a mutual fund is said to be open ended, what this means is that the fund managers are not limited in terms of how many shares of the fund itself they can create and sell.
But when fund managers choose to create more shares, this doesn’t dilute the value of each share. Rather, as more shares are created and purchased, the overall value of the mutual fund itself increases and this in turn changes the value of each share.
Closed Ended Mutual Funds
When a mutual fund is said to be closed ended, what that means is that fund managers can only create and issue so many shares of that fund.
When the maximum number of shares have been issued, it is investor demand that will drive the value of each fund share up.
Pros and Cons of Mutual Funds
In this section, we give you the major pros and cons of mutual funds as an investment option.
Pros of mutual funds:
- Fund management brings an investing expert into the mix.
- Internally diversified for more balanced risk.
- Less time-intensive investment option.
- May contain different asset classes (such as stocks and bonds) for greater risk management.
- Mutual funds can support the transition to downgrade investment risk over time.
Cons of mutual funds:
- Fund management fees can eat into profits.
- More difficult to choose for the socially responsible investor.
- Investors give up control over changes to the mutual fund portfolio.
- Minimum investment requirements can be a barrier to entry.
- Investors don’t actually own the shares – the mutual fund management team does.
Fundamental Differences Between Stocks and Mutual Funds
As you are probably beginning to pick up on at this point, the single greatest fundamental difference between stocks and mutual funds boils down to one word: risk.
There are levels of risk ranging from very low to very high. Some types of stocks, such as penny stocks, rank right up there with the highest risk assets of all time.
As a general rule, investing in straight stocks regardless of class (big-cap, small-cap, et al) will be riskier than investing in mutual funds, even if the mutual funds are stock-populated funds.
But mutual funds are still riskier as an asset category than government bonds and cash-equivalents such as certificates of deposit and money market accounts.
This is why it is smart to include both stocks and mutual funds in your investment portfolio.
How you populate your investment portfolio will change – and should change – over time.
The more time you have to invest, the more risk exposure you can bear in exchange for the potential for higher rewards.
The less time you have left to invest, the more you want to make sure you carefully guard against the risk of losing the returns you have already accrued.
Let’s take a look at how this might play out if you were to build a very simplistic diversified investment portfolio using just stocks and mutual funds that is adjusted for life-stage risk vs returns.
1. Aggressive: 100 percent straight stocks.
2. Moderately aggressive: 80 percent stocks / 20 percent mutual funds (stocks only).
3. Moderate: 50 percent stocks / 50 percent mutual funds (bonds only).
4. Moderately conservative: 80 percent mutual funds (stocks and bonds) / 20 percent cash equivalents.
5. Conservative: 50 percent mutual funds (bonds only) / 50 percent cash equivalents.
Obviously, this is wildly simplistic since we are dealing with only two asset classes, stocks vs mutual funds.
In a real-world setting, a truly diversified portfolio would likely contain a number of other asset classes as well as greater delineation between the types of stocks and mutual funds being included.
But hopefully you get the general idea. The fundamental difference between stocks vs mutual funds lies in how each can help you adjust your portfolio between potential risk and potential for returns.
When Can a Stock Be Better Than a Mutual Fund?
Stock might carry a higher degree of historical risk than mutual funds, but it is important to remember that, historically speaking, stocks have also traditionally outperformed all other asset classes to deliver the highest returns.
Clearly, stock has a valuable place in the vast majority of investment strategies.
In particular, investing in stock can be better than a mutual fund in the following scenarios:
- When you are early in your investing life stage and can tolerate greater risk in anticipation of greater potential returns.
- When socially responsible investing/transparency is a priority.
- When you prefer to avoid the higher account management fees many mutual funds require.
- When you are not able to meet the investment minimums many mutual funds require.
- When you have a good amount of time and interest to take a hands-on role in building your own investment portfolio.
When Can a Mutual Fund Be Better Than a Stock?
As you now know, mutual funds have some potential advantages that straight stocks cannot compete with.
As well, some mutual funds today are constructed using the socially responsible investing model, which is important for some investors.
At certain times in your investing life, including mutual funds in a diversified investment portfolio can make especially smart sense:
- When you are beginning to transition your portfolio for a more even blend of risk/return.
- When you simply don’t have the risk-tolerance to cope with the volatile stock market.
- When you prefer to take a hands-off role and leave the strategizing to mutual fund management experts (and you don’t mind paying the fund management fee in return for this expertise).
- When your priority is a balanced investing strategy (over focusing on the lowest fees or most transparent choices).
- When you want to invest in both stocks and bonds (or other lower-risk asset classes) but don’t want to build a piecemeal portfolio.
Stocks and mutual funds each have their place in a diversified investment portfolio. By taking the time to gain a deeper understanding of the benefits and drawbacks of each, you can make the most confident investing decisions.