Many experts agree that almost all of the advantages of stock portfolio diversification (the benefits derived from buying a number of different stocks of companies operating in dissimilar sectors) are fully realized when a portfolio holds around 20 stocks. At the point that a portfolio holds 20 stocks from 20 companies operating in different industries, almost all of the diversifiable risk associated with investing has been diversified away. The remaining risk is deemed to be systematic risk, or market-wide risk, which cannot be diversified away. Since most brokerage firms having a minimum share purchase requirement, it's hard for many investors to afford 20 different stocks.
A brokerage firm that imposes a minimum share buy of 100 shares requires investors to buy 100 shares of each stock they wish to purchase. If the average price of a share is $20, then investors buying through that brokerage firm are required to invest a minimum of $40,000 ($20/share*100 shares*20 different stocks). Most investors just don't have $40,000 sitting around to invest, so mutual funds allow investors to get the maximum benefits of diversification without having to meet any minimum required share purchases.
The convenience of mutual funds is undeniable and is surely one of the main reasons investors choose them to provide the equity portion of their portfolio, rather than buying individual shares themselves. Determining a portfolio's asset allocation, researching individual stocks to find companies well positioned for growth as well as keeping an eye on the markets is all very time consuming. People devote entire careers to the stock market, and many still end up losing on their investments. Though investing in a mutual fund is certainly no guarantee that your investments will increase in value over time, it's a way to avoid some of the complicated decision-making involved in investing in stocks.
Many mutual funds like a sector fund offer investors the chance to buy into a specific industry, or buy stocks with a specific growth strategy such as aggressive growth fund, or value investing in a value fund. People find that buying a few shares of a mutual fund that meets their basic investment criteria easier than finding out what the companies the fund invests in actually do, and if they are good quality investments. They'd prefer to leave the research and decision-making up to someone else.
Finally, the trading costs of buying and selling stocks are often prohibitively high for individual investors. So high-priced in fact, that gains made from the stock's price appreciation can easily be canceled out by the costs of completing a single sale of an investor's shares of a given company. With a mutual fund, the cost of trades are spread over all investors in the fund, thereby lowering the cost per individual. Many brokerage firms make their money off of these trading costs, and the brokers working for them are encouraged to trade their clients' shares on a regular basis. Though the advice given by a broker may help clients make wise investment decisions, many investors find that the financial benefit of having a broker just doesn't justify the costs.
It's important to remember there's disadvantages of mutual fund investment as well, so as with any decision, educating yourself and learning about the bulk of available options is the best way to proceed.
It is really a matter of diversification. An individual stock provides exposure to one company. Generally speaking, a stock in one company will be more volatile than a diversified instrument such as a mutual fund, or exchange-traded fund. On the flip side, an individual stock may be preferred for any number of reasons: good growth prospects, reliable dividend history, etc. There are some good articles on Investopedia regarding mutual funds, exchange-traded funds and stocks. I encourage you to read a few to help with your decision making processes. As you close in on a choice, post more questions. Many of us are quite happy to help! Best of luck!
What a great question! As my children start to show some interest in investing, that’s actually one of the first few questions they asked me. I like to explain a complex subject with some illustration, in words. Imagine you start a Roth IRA with $800, and you’re very tech savvy. So, you tell yourself you love Google or Alphabet so much that you want to buy one share of it, which just happens to be $800 per share. To further make things simple, you incurred no trading cost, and you bought your first share of Google with all of your Roth IRA money of $800. When things went well, your one share of Google has done fabulously. But, when a scenario of 2008 happens that causes the Google stock to drop to $400/share, you suddenly look at a very shrunken-sized Roth. All is because you put all bets in one basket. On the other hand, if you invest in a technology mutual fund that covers all tech company stocks, including your favorite Google, you spread your bets in all tech companies. If the history repeats itself, which happens, your technology mutual fund may have a negative return, say -30%, but it still beats the -50%. Happy learning and investing!
Mutual funds are actively managed baskets of stocks. It provides more diversification than an individual stock. Investing in a single company has risk. For example, if you invest $500 in one company, that could result in a complete loss of your investment if the company performed poorly. If you invest the same $500 in a mutual fund which have several stocks inside, if one company flounders, you would not lose your entire investment.
A mutual fund consists of a basket of individual stocks. Some mutual funds can have hundred’s of holdings as opposed to just owning one stock. A mutual fund will provide more diversification and protect you against company risk. Meaning if you only own one stock, your performance is based solely on the performance of that one company. Whereas a mutual fund is based on the basket of companies the fund owns.
Another advantage of a Mutual Funds is you are getting professional management from the fund company.
Best of Luck,
Joseph Carbone, Jr., CFP®, AIF®