Decide Whether to Buy Stocks or Mutual Funds

The statistics are clear — over the past 20 years equities (that is to say, stocks and mutual funds) have been the best performing type of investment, outperforming both bonds and real estate. Investing in stocks and mutual funds is an essential component of building wealth, generating enough funds for retirement, and protecting your hard-earned money from inflation. The question most potential investors have is whether to invest in stocks, or in mutual funds. To answer this, it is critical to understand the differences between each, and understand your goals and preferences as an investor.

Steps

Understanding Stocks

1. Learn about common stocks. The first step is to understand what a common stock is, because common stocks are the key ingredient to many mutual funds. Quite simply, a stock represents ownership in a business, and therefore, when you purchase a stock, you are purchasing a portion of a business, and a result, you are able to benefit in the future growth of that particular business.
   • When you purchase ownership in a business, it is done by purchasing shares, each which represent a small portion of the business.
2. Understand the factors that cause the price of a stock to change. The price of shares are determined entirely by supply and demand. That is to say, if there is a large population of individuals who want to buy shares of a particular business, the price would rise. Similarly, if there are few buyers, but plenty of sellers, the price would fall as sellers undercut each other to sell their ownership.
   • As an investor, your hope is that by a business growing and doing well over time, plenty of investors will want to buy into the company's prosperity, increasing the value of your shares. You can then sell these shares to earn a profit if you choose to.
   • It is important to remember that the price of a stock does not necessarily reflect how well the company is doing. Since a stock's price is simply determined by how many people want to buy it versus how many want to sell it, the price of a stock can increase or decrease due to general economic news, positive news in the industry, rising or falling interest rates, or reports on the company. It is not uncommon for a stock to fall or rise dramatically even when nothing has fundamentally changed about the company.
3. Learn the ways money can be made with a stock. When you purchase a stock, you can make money in two basic ways. The first is growth in the share price of the shares you own. The second is from income you receive from your stock, also known as the dividend.
   • If you buy a stock, and the business is able to grow its earnings and do well over time, the share price will typically grow with it, increasing your wealth.
   • In addition, being a shareholder of a company entitles you to a portion of the company's earnings, also known as a dividend. Not all companies choose to pay a dividend (some prefer to use their profits to re-invest in the business and earn more profits), but that ones that do will pay you a distribution monthly, quarterly, semi-annually, or annually.
   • The dividend payment is a percentage of the value of the shares, also known as the "yield." The yield represents the total dividends paid over the course of the year divided by the price of the shares. For example, if a share is worth $10, and the dividend is $1 annually, the yield would be equal to 10%. (1/10=0.1 or 10%)
4. Educate yourself on the advantages of investing in stocks. There are multiple advantages to investing in stocks. Generally speaking, the major appeal of stocks is that they offer potential for higher returns both through share price increases, as well as dividends.
   • Higher returns than other investments: The main advantage of purchasing stocks is the potential for returns above what could be obtained by investing in different asset classes (or types of investments). Stocks have traditionally outperformed other asset classes like bonds or real-estate over the long-term.
   • Diversification: Owning stocks can also be useful for diversification. For example, if your only asset is your home, this would mean your entire wealth is subject to the housing market. By adding stocks, your wealth is partially allocated to a different asset class, which may not rise and fall with home prices.
   • Potential for high yields: Stocks can also provide income that is competitive with or exceeds other types of investments. There are stocks with secure dividend yields of three to four percent, which is highly competitive with any other type of investment.
   • Affordability: Stocks are also fairly affordable to purchase if you purchase on your own through a brokerage. When you purchase a stock, you typically pay a commission when you buy and again when you sell. You are not charged a percentage of your total investment amount each year.
5. Educate yourself on the disadvantages of investing in stocks. While stocks do offer the potential of higher returns than other asset classes, these higher returns do come at the price of additional risk.
   • Potentially high risk: The major disadvantage of investing in stocks is that they can be higher risk than keeping your money in cash, real-estate, bonds, or treasuries. When investing in a stock, there is always the potential to lose some — or all — of your capital.
   • High knowledge and time requirement: Purchasing individual stocks does require knowledge and time, which can be seen as a disadvantage. It is not advisable to invest in a company unless you properly understand how to assess whether the investment is sound or not.
   • Volatility: Stocks are also more volatile than other types of investment. This means that stocks can change price rapidly in a short period of time. This is an issue if you need cash quickly and the stock is down.

Understanding Mutual Funds

1. Learn the definition of a mutual fund. A mutual fund is a collection of stocks that are professionally managed by a portfolio manager in exchange for a fee. When you purchase a mutual fund, you are pooling your money with many other investors, and the portfolio manager will use his or her expertise to buy stocks that he or she believes will perform well over time.
   • When you purchase a mutual fund, you receive "units" of that particular fund. A unit can be seen as identical to a share, and the unit represents your ownership in the collective pool of funds.
   • The collective value of the pool of investments is known as the "Net Asset Value" or NAV. When the NAV increases, the value of your mutual fund units also increase. The NAV would increase due to the portfolio manager investing in stocks that increase in value.
2. Learn how money is made with a mutual fund. You make money on mutual funds in the same ways you make money on stocks. The value of your mutual fund units will rise depending on how the underlying stocks do, which increases you wealth over time, and which you can sell for a profit.
   • You can also receive income from your mutual funds, similar to a stock dividend. If the stocks in the fund pay dividends, the portfolio manager will often pass those earnings on to you in the form of a monthly, quarterly, semi-annual, or annual payout.
   • Some mutual funds also have an additional pay-out known as a capital gains distribution. This simply means that when the mutual fund sells a stock for a profit, they will distribute the profit to you.
3. Compare the advantages of purchasing mutual funds compared to stocks. There are numerous advantages to purchasing mutual funds compared to both stocks, and other types of investments.
   • Professional Management: The major advantage to purchasing a mutual fund compared to a stock is that you can benefit from the fund's professional management. Investing can be a highly complex, time consuming, and risky activity, and many investors simply do not have time, knowledge, or desire to manage a portfolio on their own. Purchasing units of a mutual fund allows an investor to pass on this responsibility to a qualified portfolio manager.
   • Diversification: This is arguably the biggest advantage to purchasing mutual funds. By definition, a mutual fund is a collection of stocks. Therefore, when you purchase a unit in a mutual fund, you are often purchasing a basket of dozens to hundreds of different stocks. This protects you from the risk of any single company failing or doing poorly. Obtaining this sort of diversification on your own is often impossible, since purchasing hundreds of stocks would not only be expensive (due to fees), but also impossibly time consuming to manage. More diversification means lower risk.
   • Simplicity: While one of the disadvantages of buying individual stocks was that they do require significant knowledge and time to research and manage, mutual funds are attractive in the sense that they require little knowledge or time to invest in or manage.
4. Compare the disadvantages of purchasing mutual funds compared to stocks. While mutual funds offer professional management, simplicity and low-risk due to diversification, these advantages can also be disadvantages.
   • Professional management costs money, and fees are one of the major downfalls compared to purchasing individual stocks. Typically, mutual funds will charge between one and three percent of the total value you have invested each year, and these fees are charged regardless of the fund's performance. In addition, mutual funds typically charge a commission either when the fund is purchased, or when the fund is sold. This commission would go to your adviser or to your broker.
   • Too much diversification can eliminate returns. While diversification can prevent you from suffering losses due to a single company performing poorly, it also prevents you from benefiting from a single company performing exceptionally well.
5. Learn the different types of mutual funds. While mutual funds do consist of a diverse range of stocks, the stocks included in a fund are typically not random. Rather, mutual funds are often organized to include stocks with particular characteristics as to appeal to investors with differing goals and risk tolerances.
   • Domestic stock Index funds (for example S&P 500, NASDAQ, Dow Jones Large-Cap Value Index) can allow investors to bet on the performance of not just one company, but on the entire market. For example, purchasing an S & P 500 index fund allows you to benefit from the overall market doing well.
   • Large-cap mutual funds are a good option for investors seeking low-risk and slower growth because they pool together the stocks of companies with a large market capitalization exceeding $10 billion each. In contrast, Small-cap funds of companies (with market capitalization less than $2 billion) have a higher capacity for growth and return on investment. However those same small-cap companies may also be more vulnerable to economic downturns, and so that potential opportunity for higher growth comes with a higher risk for loss.
   • Growth funds are collections of higher-risk stocks that promise the possibility of higher returns.
   • International and global stock funds pool together stocks from around the world, including the United States. Some funds invest in companies located in emerging market countries, adding additional risks and potentially higher rewards.

Determining Which Type of Investment Is Right for You

1. Assess your risk tolerance. The first step to choosing individual stocks versus mutual funds is to understand your risk tolerance. Due to diversification, purchasing mutual funds is typically lower risk, as your investment will be mostly immune from the risk of one company performing poorly.
   • If you are uncomfortable with the idea of potentially substantial losses, investing in mutual funds is likely a better choice. While mutual funds can and do lose money (due to the overall market doing poorly, or entire industries that a mutual fund may be over-concentrated), the risk is generally lower due to low risk of poor performance by one stock.
   • Mutual funds also provide greater opportunity to customize your risk level by purchasing different types of funds, or investing in low-risk funds. While mutual funds are very diversified, they are often organized according to stocks with differing characteristics. By purchasing multiple funds, you can attain a level of diversification and risk reduction that would be very difficult to replicate with stocks.
   • For example, you could purchase a Large-Cap domestic fund and an international fund. This would not only immunize you to the risk of a single stock failing, but also to the risk of the U.S. economy or stock market doing poorly.
2. Assess your personal characteristics. Ask yourself honestly if you have the time, interest, or knowledge to manage a portfolio of your own stocks. If you are knowledgeable about investing (or have time to learn), and prefer having full control over your finances, buying individual stocks can present an attractive opportunity.
   • If you feel you have the time, knowledge, and expertise to buy individual stocks, be aware of the risks. A recent study found that while looking at 3,000 stocks over a 24 year period, 39% of stocks were unprofitable, 19% lost 75% of their value (or more), and 64% under-performed the overall market. Just 25% of the stocks were responsible for all the market's gains. This shows the difficulty of picking successful stocks.
   • Individuals who are successful, however, have the potential to earn returns significantly above what could be earned by investing in a mutual fund.
3. Identify your investing duration. When you invest your money, you will likely have a time line as to when you will require the money. If you are investing for retirement, for example, and are fairly young, this timeline may be several decades. Conversely, if you are in your 50's or 60's and investing for retirement, you may require the money in a few years. Typically, higher-risk investments (like stocks) are more appropriate if you have a longer duration until you require the money.
   • Investing in stocks is desirable if you have a long period until the money is required. This is because it allows you significant time to recover any losses. For example, if you invest $30,000 intended for retirement in your 20's and lose the entire sum, you have several decades to re-accumulate the sum. The same loss in your late 60's could be catastrophic.
   • Therefore, it is wise to select mutual funds for any funds that you will need within a short time frame. With mutual funds the likelihood of the value declining substantially is much lower, thereby preserving your wealth for when your require it.
4. Consult your financial institution. A financial adviser can be an excellent resource in terms of helping to establish not only whether to utilize stocks or mutual funds, but also to guide you in selecting specific stocks or mutual funds to purchase. Advisers will often do so after having a conversation with you about your goals, risk-tolerance, and knowledge.

Establishing your Investment Brokerage Accounts

1. Determine how much money you can afford to invest in the market. Because stock and mutual fund purchases can drop in value, particularly in the short-term, you should never invest money you might need for short-term living expenses or in case of an emergency. Consequently, you should adequately finance several essential non-market obligations prior to investing in the market.
   • Set aside an emergency fund to cover six to 12 months of your household living expenses. Emergency funds need to be liquid and secure. They could be a bank checking or savings account, or a money market fund within a Roth IRA. Don’t forget to fund your insurance needs: health, car, life, home owner’s or renter’s insurance, possibly long term care insurance.
   • Pay down higher interest debt, especially higher-interest credit cards. Understand how much total interest you save by making extra payments on your longer-term debts and liabilities. Paying off lower interest student loans is particularly important because that debt cannot be discharged through bankruptcy. Tip: While you do not have to pay off all loans and mortgages completely before investing, you should at least be making active payments on your loans, and keep them out of deferment.
2. Open a tax deferred traditional IRA though your employer. If your employer does not offer this benefit, try to find a well-established highly-visible brokerage and investment firm that you trust will put your interests first. Avoid brokers who encourage you to make investments you do not understand.
   • Seek out and attend any retirement investment seminars offered by your human resources department. Explore any investment resources and research tools available on your financial institution’s website. Schedule a one-on-one in person or phone meeting with a financial advisor at your financial institution to discuss your goals and options.
   • Understand the tax shelter benefits of the retirement account, how the investments in IRA are funded with pre-tax dollars (up to $5500 per year, $6500 if you are over 50 years old) and are allowed to grow tax-free until you cash out.
   • Understand the 10% penalties to withdraw retirement funds before 59 ½, and that all non-Roth IRA withdraws qualify as taxable income.
   • TIP: If your employer offers a matching contribution, always invest the maximum to take advantage of this benefit.
   • Consider opening a supplemental IRA if you can afford to maximize your contribution to your traditional IRA and can still afford to invest pre-tax dollars into a tax shelter.
3. Establish a Roth IRA. A Roth IRA is widely considered the smartest place to invest your after-tax ordinary income dollars.
   • Roth IRAs are funded with after-tax dollars (up to $5,500 per year, $6,500 if you are over 50 years old), are allowed to grow tax-free, and your eventual withdraw is tax-free.
   • An added bonus: you can withdraw your contributions (but not the earnings) penalty-free before age 59 ½.
4. Open a non-retirement brokerage account, with no tax shelter benefits. Look for an account that offers low commission fees, easy-to-use tools for funds research, and convenient access to advisers. Other perks may include a cash management account with ATM fee reimbursement or credit cards that pay back high rewards.

Tips

• If your employer offers a matching contribution, always invest the maximum to take advantage of this benefit.
• If you are just learning, you may keep most or all of your account in a Money Market until you identify other funds with higher risks and return potential that you comfortably understand. You can use your brokerage website's "watch-list" tool to monitor stock and mutual fund performances in a hypothetical portfolio, without risking an actual loss.
• Electronic Trade Funds offer the diversification of mutual funds, with the trading flexibility and typically lower expenses of stocks.
• Dollar cost averaging is an investment strategy that will reduce the risk of a volatile market. When you divide an investment purchase into several equal parts with an equal amount of time between each purchase, you protect yourself against the risk of buying-in at the single worst possible moment (right before a bubble pops and your investment’s industry/sector/company crashes).

Warnings

• Not investing in the market carries its own risk of loss to inflation. Individuals who keep cash in the safest money market accounts (or in their freezer or mattress) can expect their money to buy less in the future than it buys today. Predicting exact rates of inflation is like trying to predict the weather, but you might presume your investments need to earn roughly 2.5% to be able to keep up with inflation in the long-term.
• Because a stock’s price reflects the market demand, its purchase price will be higher if a company’s opportunity for growth is common public knowledge. Consequently, your potential return on investment in that company’s stock will be lower unless you get in on the ground floor and invest before the market realizes what you may already have known.

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