There are a number of reasons why an individual may choose to buy mutual funds instead of individual stocks. The most common advantages are that mutual funds offer diversification, convenience, and lower costs.
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 holds 20 stocks from companies operating in different industries. At that point, a large portion of the risk associated with investing has been diversified away. The remaining risk is deemed to be systematic risk, or market-wide risk. Since most brokerage firms charge the same commission for one share or 5,000 shares, it can be difficult for an investor just starting out to buy into 20 different stocks.
The convenience of mutual funds 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. If you want to track the overall market, you can buy an index fund. You can diversify into non-equity asset classes by buying a bond fund, which invests only in fixed income.
Some investors 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 frequent stock trades can add up quickly for individual investors. Gains made from the stock's price appreciation can be canceled out by the costs of completing a single sale of an investor's shares of a given company. Investors who make a lot of trades should take a look at our list of brokers who charge lower-than-average fees.
With a mutual fund, the cost of trading is spread over all investors in the fund, thereby lowering the cost per individual. Many full-service 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 are 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.
Most online brokers have mutual fund screeners on their sites to help you find the mutual funds that fit your portfolio. You can also search out funds that can be purchased without generating a transaction fee, or funds that charge low management fees. The search function can also let you locate socially responsible funds.
Joe Allaria, CFP®
CarsonAllaria Wealth Management, Carbon, IL
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.