How to decide whether to buy stocks or mutual funds

Over the years equity market has performed well in comparison to any other type of investments such as bonds and real estate. All of these financial assets have their own pros and cons. The question is: where should you invest? If it’s equity, should you start investing with stocks or mutual funds?

To know the answer you have to first understand the difference between stocks and mutual funds. After that you need to understand your long term financial goals, investing experience, risk tolerance and preference as an investor.

Stock Vs. Mutual Fund – What is the difference

Let us discuss the difference between mutual funds and stocks from an investing point of view. In this article we will be discussing equity mutual funds and its comparison to stocks.

You also have different types of mutual funds which invest in stocks as well as other financial assets such as debt.

Before getting into the differences, first let’s understand what a stock and mutual fund is.

What is a stock?

We have already discussed what is common stock. You can read that article to know what it is and why people invest in common stock.

Here, we are giving you an overview in order to understand the difference between stocks and mutual funds.

Stock represents ownership of a business. When you buy stock of a company, it means you have purchased a portion of that company’s business in proportion to the total number of shares outstanding.

As a owner, you can make money in two ways;

You get a dividend when the board of directors decide to pay you. Capital appreciation is the difference between market price and your buying price. When you sell your stock, the difference between selling price and buying price will be known as capital gain.

What is a Equity mutual funds ?

Equity mutual funds are a collection of stocks. In it you don’t decide which stock to buy and sell in the stock market. On your behalf, a professional manager is appointed to decide what to sell and buy from the stock market.

Remember, common stocks are one of the key ingredients of equity mutual funds. When you invest in it, you are indirectly putting your money in stocks through a fund manager.

Total value of all the securities held in the mutual funds divided by the number of shares is known as net asset value or NAV. Based on the amount you have invested,  you will have proportionate ownership in the company’s NAV.

Net asset value is determined at the end of each business day. You can place orders for mutual funds at any point of time, but your order will be executed based on the closing NAV of that day. In this way, you can not control your buying price which can be controlled while buying stocks.

Now let’s get into the key differences between stocks and mutual funds.

Management

When you invest in a stock or in a number of stocks, you manage your portfolio. To get started you have to educate yourself to know each and everything of the stock market, starting from doing your own research on a company’s fundamentals, market performance, economy outlook etc.

It requires time and lots of effort. If you are ready and capable of doing that, then you will definitely succeed.

If you don’t have time and expertise, better to take mutual funds route. The biggest advantage is that they are professionally managed by fund managers.

By buying certain units of mutual funds, you pass on the responsibility of research, tracking market activities and other things required for stock market investing to a professional portfolio manager, who is qualified to do that on your behalf.

As an investor in mutual funds, you can not decide which stock to buy and hold.

Risk tolerance level

The first step before investing in risky investments is to understand your risk tolerance.

If you are a conservative investor, you can buy fundamentally sound stocks from defensive sectors, blue-chip stocks with a history of performance and any large players which have leading positions in the industry.

In general stocks are more riskier than equity mutual funds, it’s primarily due to the kind of diversification you get in equity mutual funds.

You can even buy different types of mutual funds in order to lower your risk in a particular sector or type.

Diversification in Stocks and Mutual funds

Mutual funds are well diversified by investing in a number of different stocks. By buying certain units of mutual funds, you are basically purchasing a basket of stocks from different companies.

This diversification protects you from all types of risk that is associated with a business and industry. Due to this diversification, failure of a single company will have negligible impact on your portfolio.

As an individual investor, it will not be possible for you to diversify your portfolio as its in case of mutual funds. It will be very difficult to manage and time consuming.

Based on the capital you have, if you have invested in a few stocks and two or three of them failed due to your mis-management, then it could have a big impact on your overall return. You can eliminate this type of risk by diversifying into different stocks of different industries. However, managing more number of stocks can be challenging if you are a beginner.

Cost of investing

One of the biggest disadvantages of mutual funds is the cost of managing the fund.

Professionals who manage your capital in a mutual funds charge their fees in addition to other costs. On an average they will charge 2-3% of your total capital invested each year regardless of how the market is doing. In addition to the cost you will also be paying commission while buying the mutual fund.

You need to decide whether the cost compensate the services that you get from the professional managers. If Yes, then go for it. If No, do your own research and start investing.

Where should you invest? Stocks or mutual funds

Now you know the key difference between stocks and mutual funds. Both financial assets have their own pros and cons. 

To find out which one suits you best, depends on your investment style, risk tolerance, return you want and goals. 

Before choosing your way of investing in the stock market, here are few good questions you need to ask yourself in order to determine which fits best with your investment style;

  • Do I have time, interest or knowledge to manage my own portfolio of stocks?
  • Can I invest enough money in lump sum to have a diversified portfolio?
  • Can I manage my money professionally?
  • Do I have a good risk tolerance level? Am I a risk taker?
  • Can I sleep at night peacefully if the stock market falls 20% to 30% in six months or a year?
  • Do I know how to diversify my portfolio based on different risk factors?
  • Can I spend sufficient time or are willing to spend time on research of investments?
  • Do I know how to read financial reports?
  • Do I have patience to learn how to evaluate financial statements?
  • Can I analyse to know how much money the company makes, from where income comes from and how the company’s earnings can grow over the years?

If the answer to most of these questions is NO, then better to invest through a good financial advisor or professionally managed mutual funds.

is a fellow member of the Institute of Chartered Accountants of India. He lives in Bhubaneswar, India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.