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Is it Better to Own Individual Stocks or Mutual Funds?

Choice May Not Be Necessary


Investors in the stock market can be divided into many camps, such as:

  • Value investor or growth investor
  • Buy and hold or short-term trader
  • Cautious or risk-taker
  • Invests in individual stocks (and bonds) or mutual fund investor

Of course this is overly simplified and leaves out a number of other types of investors in the stock market, but it does point out some of the options for investing open to investors.

You will find vocal and passionate adherents to some of the investing strategies. For instance, there are those who swear by buy and hold and another group that considers that strategy out dated and inferior.

One of the other areas of dispute involves whether you should own individual stocks and bonds or stick with mutual funds.

Many people who invest in individual stocks probably own some mutual funds also.

Mutual funds have some attractive qualities:

  • Professional management
  • Easier diversification
  • Liquidity
  • Wide selection

Not all mutual funds have the attributes listed above. Many funds underperform the major market index - the S&P 500.

Some mutual funds carry high fees and onerous withdrawal penalties. Some funds give a false sense of diversification, but their portfolios contain similar enough stocks that a turn in the economy can be a disaster.

If you are careful, it is possible to find funds with low costs (one of the major determinants of fund profits), good managers and true diversification.

If you participate in a sponsored retirement plan such as a 401(k), you most likely have a selection of funds to choose from.

Investing in mutual funds demands many of the same skills as investing in individual stocks. Foremost is research.

There are many websites that offer comprehensive research on mutual funds. MorningStar is one of the best in my opinion. They have tons of free information and for a modest monthly subscription you get access to even more detailed information and rankings.

You can find screens and other tools to help you decide. Just remember, the higher the fees, the harder it is for you to earn a decent return.

So, why would an investor want to buy individual shares of stock?

There are several good reasons and some bad ones.

Investing in individual shares is often less expensive than paying mutual fund fees. There is no cost beyond the broker's fees when you buy and when you sell.

With low-cost online brokers, this expense is minimal. Mutual fund holders pay fees whether they sell or not.

Both mutual fund owners and owners of individual shares of stock may have tax liabilities. In fact, mutual fund holders may face more taxes depending on the fund.

If investors do their homework, purchasing individual shares of stock carries only as much risk as the investors are willing to bear.

Poor choices will result in a disappointing outcome regardless of whether the investor buys mutual funds or individual stocks.

The issue and challenge to investors owning individual stocks or bonds is to find a portfolio that provides sufficient opportunities for growth with enough diversification and proper asset allocation to weather stock market shocks.

In the end, most investors are better off owning both mutual funds and individual stocks.

A few good mutual funds will help investors with the diversification that offers some protection during swings in the economy. Index funds that track major market indicators are often good choices, especially because many carry very low fees.

A select choice of individual stocks offers more potential for gain, while keeping risk within reasonable limits provided you have sufficiently done your homework.

Advice that you should only own stocks or only own mutual funds is misguided.

Ask questions and question assumptions.

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