You may be wondering if it’s best to buy mutual funds vs stocks. In this post, I’m updating an article I wrote back in early 2008! A lot has changed in the investing world since then. Not only did we go through that nasty, nasty market correction in 2008 – 2009, but there has been a proliferation of funds from which investors can choose. Let’s start with the basics of just what mutual funds are.
What Is A Mutual Fund?
A really smart, well respected guy named Jack Bogle realized that it would be much easier for people to be able to buy stocks as a group through a fund rather than individually. He promoted this idea in the 1990’s. By doing so, he revolutionized investing with this concept at the company he founded, Vanguard. They are still the low cost leader in mutual funds. Bogle further promoted a certain type of funds called index funds, which I explain below.
In investing lingo, a mutual fund is an investment company that is registered with the SEC (U.S. Securities and Exchange Commission). It contracts with an investment manager who invests money for the people who buy into the fund on their behalf. There are several benefits to mutual fund investing over buying individual stocks, which I’ll outline below. You’ll want to understand mutual funds since there’s a good chance you’re invested in them if you have money in the stock market, unless you’ve bought individual stocks.
First, Let Me Mention Two Things
It’s important that you first be aware that there are passive mutual funds and active mutual funds. As the name implies, a passive mutual fund simply buys the index. An index is a basket or a group of stocks with a commonality. You’ve probably heard me harp on and on about how important yet simple it is to understand an index. If not, read here. There is no work involved. The fund manager (or the software, more realistically) buys the index.
An active mutual fund, on the other hand, has a top notch stock selector who chooses what to buy, often with the help of a team.
Second, there are all types of mutual funds. There are stock funds, real estate funds and bond funds. There are funds within each category, like gold stocks, or international bonds. In this article, I’ll refer to stocks, but remember that mutual funds apply to all types of investments.
Since enormous amounts of money are pooled together in these funds, investing through a fund allows individual investors to own a a tiny amount of a bunch of different companies. This is known as diversification. Most individual investors would never be able to get the same level of diversification on their own that they get from investing in a mutual fund.
Let’s say that you get super lucky and inherit $100,000. You could do lots of research and buy $10,000 worth of ten different stocks. Alternatively, you could research mutual funds, and put the entire $100,000 into one fund. By owning the fund, you would, in essence, own a tiny bit of hundreds, or even thousands of companies.
This applies to both active and passive mutual funds.
Full Time Investors Buy for You
Another frequent advantage of owning active mutual funds vs stocks is that you have an expert stock selector, or team of experts, choosing stocks for you. These are people that nerd out over balance sheets, analytics and charts. They love researching and choosing stocks. There is also a large research department to help choose the securities to buy for the fund.
As you probably guessed, this expert stock selector only exists with active mutual funds.
It takes much less time to invest in mutual funds vs stocks. This is because you can research a mutual fund occasionally when you’re ready to change your investments. When you own stocks, you need to do the initial research in both the company and it’s industry, as well as stay on top of company news. (Remember, with both mutual funds and stocks, you’ll want to be aware of the overall stock market valuations relative to history before buying.)
Mutual funds are required to produce a prospectus that is a legal document which all open-end funds must make available to anyone who wants to buy shares in the fund. You’ll want to read that.
In investing lingo, goals are called objectives. All funds have objectives. They are usually called growth, meaning the value will increase, income, meaning that you’ll be paid income while you own the fund, usually in interest or dividends, or preservation of capital, meaning your money isn’t lost. Clarifying these objectives prioritizes the goals of the fund. It allows you to research quicker based on your financial goals of income or growth, which I explain in this video. You can rarely have it all. (But every now and then you can, if you sharpen your investing prowess!)
In other words, if preservation of capital is the main goal, you’re going to give up some of the likelihood that your fund will grow. The same is true if income is the main objective. If income is the main objective, you’re probably going to give up some growth. The fund objective can also give you a good idea of the risk involved in investing in any particular fund. The caveat is that if you invest in an overvalued market that is ready to drop, even funds with preservation of capital as a main goal can tank. This is why diversification is so important by investing in different types of investments.
You’ve Got to Have Some Money to Invest
Mutual fund companies require a minimum amount to be invested. Frequently, the minimum is $ 2,500, but it may he as high as $250,000 or more. When you buy a fund, you can elect to reinvest the annual earnings from the mutual fund back into the fund automatically, or have the proceeds given to you. Hint: For tax and tracking purposes, it’s usually easier to not reinvest. On the other hand, automatic reinvestment encourages putting away more money. You also have the advantage of getting in the fund at various price points as the value goes up and down over time when you reinvest automatically.
But Here’s the Surprising Thing…
Active mutual funds rarely perform better than passive mutual funds. This is very counter intuitive. It seems like the fund that has the expert stock selector working hard would do so much better than just buying an index. Nevertheless, studies repeatedly show that only about 10% of active mutual funds beat passive index funds. This is where knowledge of investing comes in handy. Understanding the basics of investing allows you to select those rare active mutual fund winners. It can also make sense to just go with the index.
Only you can decide what is best for you once you know the basics of investing. This is true whether or not you work with a financial advisor since you’ll need to hire and monitor your advisor. You’ll, of course, want to understand where your money is, also. This seems silly to mention, but it’s amazing that a lot of women don’t really know how their money is invested. (Reality: Not knowing how your money is invested is the same as not knowing where your money is.)
Active mutual funds perform a little better when the stock market is doing down vs when stocks overall are going up, which I won’t go into here. The good thing is that it is super easy to buy mutual funds, and index funds are even easier to buy index funds because they require even less research. Financial advisors use both index funds and actively managed funds, depending on their style. (And now you know how to have a great conversation about passive vs active funds with your financial advisor, if you have one:)
Doing Your Basic Research
There’s much more to know, but this is a primer. Before you invest in anything ever, understand what you’re investing in. Check the fees. Check how your taxes could be affected.
Be sure to check the price tag of the overall market before investing in it. In other words, where is the stock market relative to history? Has it been beaten to a pulp? If so, everyone hates it. Has it been straight up for eight years? If so, everyone loves it.
Again, the topic of mutual funds is extensive. If you’ve read this full article, you have an understanding of the basics of investing in mutual funds. Feel free to ask questions below, remembering that I write for educational purposes only and do not give personal financial advice. (I have to say this:) Hopefully, this gave you a good understanding of why most investors choose mutual funds vs. stocks.