Why would a person choose a mutual fund over an individual stock?
A mutual fund will provide diversification through the exposure to a multitude of stocks. The reason that is recommended over owning a single stock is that owning an individual stock would carry more risk than a mutual fund. This type of risk is known as unsystematic risk. Unsystematic risk is risk that CAN be diversified against. For example, by owning just one stock, you would be carrying company risk that may not apply to other companies in the same sector of the market. What if their CEO and executive team leaves unexpectedly? What if a natural disaster hits a manufacturing center slowing down production? What if earnings are down because of a defect in a product or a lawsuit? These are just a few examples of the types of things that COULD happen to ONE company, but are not likely to happen to ALL companies at once.
Yes, there is also systematic risk, which is risk that you CANNOT diversify against. This would be similar to market risk or volatility risk. It should be understood that there is risk associated with investing in the market. If the market as a whole declines in value, that is not something that can easily be diversified against.
Therefore, if you'd like to invest in individual stocks, I would recommend researching how you can compile your own basket of stocks so that you don't own just one stock. Make sure you are sufficiently diversified between large and small companies, value and growth companies, domestic and international companies, and also between stocks and bonds, according to your risk tolerance. This is where it might be helpful to seek out professional help when constructing these types of portfolios. This type of research and portfolio construction and monitoring can take quite some time.
The alternative is to invest in a mutual fund for instant diversification...of course, there are a list of things to be aware of when choosing mutual funds as well. Fees, investment philosophy, loads, and performance are just a few components to consider when evaluating mutual funds.
These are just a few things to consider when discussing mutual funds vs. stocks.
Joe Allaria, CFP®
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.
These two strategies are not mutually exclusive and can compliment each other at the portfolio level. But there are many reasons for using funds with the main reason being easy, quick diversification with just one or two transactions. So, with just one trade, you can buy the entire S&P 500, the largest 500 companies in America, either using a conventional mutual fund or an exchange traded fund (ETF). An ETF is my preference because it trades during the day like a stock rather than getting the net asset value, or NAV, at the close of the day.
With an individual stock, you have company specific risks known as unsystematic risk. This is the risk an individual company might get into trouble or possibly even going bankrupt. Having a plant blow up, an oil spill like the Exxon Valdeze or the BP Gulf Spill, food poisoning like Chipotle, accounting "irregularities" and a multitude of other things are examples of unsystematic risk. Even the CEO having an affair with his personal assistant could greatly affect the stock price, even though it really doesn't have anything to do with the fortunes of the company. Unfortunately, it is all about perception, especially with social media these days.
So if you are going to own just individual stocks, you need to have enough to invest in numerous companies to diversify away from company risks. If you have enough companies, you can diversify away from specific risk and just have systematic, or market risk. That is the risk of the overall market. Most studies show that if you own between 14-22 companies across different sectors in the S&P 500, you will track that index very closely with very little "tracking error." But now you have the increased cost of 15 or more trades. So, there is a tradeoff between tracking error and transaction costs.
With just 3 or 4 trades, you could own the S&P 500, the NASDAQ Index, and the Russell 2000 Small Cap Index. Thus, you could own a combination of mature, large companies, companies specializing in innovation biotech and technology, and the total broader market in small caps. In fact, there are even Total Market Index Funds where one trade can get you all of the above and you will have a mix of the total market.
Along that same methodology, if you believe a particular sector is going to benefit, but don't want to guess or figure out which individual stock is best, you can invest in a sector fund. For instance, a couple of months before the election, both candidates were talking about building out our infrastructure and we believed transports would benefit under either party. We took a position in the DowJones Transports Index using an ETF and it has worked out beautifully thus far.
If you used an individual stock, you could be right about your belief in a sector but dilute your strategy with an individual stock. The whole sector moves up with the exception of a couple of stocks, which may be yours.
The reason for using an individual stock is if you do lots of in-depth research and you like the story and prospects of that individual stock, you feel there is an opportunity that funds don't offer. You have the potential for larger returns, but that is coupled with more risks.
But let's take a look at combining the two at the portfolio management level. For instance, you use ETFs for say 60% of the portfolio and then 40% for individual stocks. The ETFs can be 10% for sector ETFs and 15% to 20% for broad index ETFs like the S&P 500. Then regarding stocks, no one individual stock can be more than 5%, so that you have 8 individual companies you believe to be the best of the best. These are your core holdings. If you then believe the market is getting more dangerous, you can raise 20% cash, therefore reducing volatility/risk by selling just one or two ETFs. If the markets continue to weaken, you can peal off another few positions so you have 40% cash while holding some key, core positions.
This is known a strategic versus tactical allocation. The strategic is a more long term buy and hold whereas the tactical is taking advantage of the current environment. This is active management, not passive however. Many advisors will just give you a pie chart based upon your station in life - age, risk tolerance, etc. I personally believe making money is more about the risks in the markets themselves and the market's time frame, not yours. You need to take both into consideration. I am just trying to get you to think beyond just one versus the other, because again, they are not mutually exclusive. Both mutual funds/ETFs and stocks are tools to get you where you want to go. Both have advantages and disadvantages.
But in summary, to answer the way you asked the question, the primary reasons for using funds or ETFs are lower costs and diversification. Funds need less ongoing attention and diligent research. Both are good strategies and we use a combination of both in concert. In fact, they compliment each other on a portfolio management level.
Hope this helps to stimulate your thought processes. Happy Holidays, Dan Stewart CFA®
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!