Mutual funds, a type ofinvestment where the money from multiple investors is invested together in several stocks,offer advantages over individual stocks, including diversification and convenience.
Key Takeaways
- A pooled investment such as a mutual fund allows investors to diversify their holdings and reduce investment risk.
- Mutual funds offer convenience because investment decisions are left to a professional fund manager.
- Some investors prefer an index mutual fund, which tracks a market index and generally has lower fees compared with actively managed funds.
Reducing Risk With Diversification
Investing in only a handful of stocks is risky because the investor's portfolio is severely affected when one of those stocks declines in price. Mutual funds mitigate this risk by holding a large number of stocks. When the value of a single stock drops, it has a smaller effect on the value of the diversified portfolio.
For example, suppose a person owns 10 shares each of two stocks, with each sharevalued at $100. If the price of one of the stocks falls by 25%, the value of the portfolio declines from $2,000 to $1,750, a drop of 12.5%.
If the portfolio consists of one share each of 20 stocks, each valued at $100, then a decline of 25% in the price of one stock brings the value of the portfolio from $2,000 to $1,975. This is a decline ofonly 1.25% in the value of the overall portfolio.
Mutual Funds Offer Convenience
In addition, investing in mutual funds is more convenient than investing in individual stocks because the manager of the fund researches stocks and decides which ones to purchase. An investor buying individual stocks has to make these decisions for themselves. However, the downside of this convenience is the fee a fund manager charges, which reduces the amount investors can earn from the fund.
While mutual funds are diversified and convenient, whether investing in them is an ideal way to maximize returns is a matter of debate among economists. Those who support the efficient market hypothesis believe investors who buy individual stocks are generally unable to achieve returns as high as the returns of the market as a whole.
Thus, they recommend people invest in index funds, which are mutual funds that track a market index and generally have low expense ratios. Other economists dispute this hypothesis and argue that buying individual stocks has the potential for higher returns than mutual funds.
FAQs
A mutual fund provides diversification through exposure to a multitude of stocks. The reason that owning shares in a mutual fund is recommended over owning a single stock is that an individual stock carries more risk than a mutual fund. This type of risk is known as unsystematic risk.
Is it better to buy mutual funds or individual stocks? ›
Mutual funds have several advantages over individual stock picking. Beyond diversifying your holdings, some mutual funds aim to outperform the stock market, while others mirror a popular index like the S&P 500.
Why would someone choose to use a mutual fund instead of single stocks? ›
The most common reason someone would choose a mutual fund over a stock is that it's a convenient, hands-off way to profit from the stock market without any active management on their part. It's also an easy way to diversify your holdings, which isn't the case when you purchase a single stock.
What is the biggest advantage to owning a mutual fund over an individual stock? ›
Diversification. Mutual funds give you an efficient way to diversify your portfolio, without having to select individual stocks or bonds. They cover most major asset classes and sectors.
What are 3 advantages and 3 disadvantages of investing in mutual funds rather than stocks or bonds directly? ›
Mutual funds come with many advantages, such as advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing. Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.
Why is it so important to avoid buying single stocks and invest in mutual funds instead Ramsey? ›
Well, we like mutual funds because they spread your investment across many companies, and that helps you avoid the risks that come with investing in single stocks and other “trendy” investments (we're looking at you, Dogecoin).
What is a better investment than mutual funds? ›
Mutual funds and ETFs may hold stocks, bonds, or commodities. Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.
Which mutual funds outperform the S&P 500? ›
10 funds that beat the S&P 500 by over 20% in 2023
| Fund | 2023 performance (%) | 3yr performance (%) |
|---|
| MS INVF US Insight | 52.26 | -47.18 |
| Sands Capital US Select Growth Fund | 51.3 | -20.88 |
| Natixis Loomis Sayles US Growth Equity | 49.56 | 26.07 |
| T. Rowe Price US Blue Chip Equity | 49.54 | 5.81 |
6 more rowsJan 4, 2024
All funds carry some level of risk. With mutual funds, you may lose some or all of the money you invest because the securities held by a fund can go down in value. Dividends or interest payments may also change as market conditions change.
Is mutual fund really beneficial? ›
Mutual fund investments when used right can lead to good returns, keeping risk at a minimum, especially when compared with individual stocks or bonds. These are especially great for people who are not experts in stock market dynamics as these are run by experienced fund managers.
Mutual funds offer diversification or access to a wider variety of investments than an individual investor could afford to buy. Investing with a group offers economies of scale, decreasing your costs. Monthly contributions help your assets grow. Funds are more liquid because they tend to be less volatile.
Is it best to invest in mutual funds? ›
We all know that mutual funds are an ideal investment avenue for leveraging capital markets, offering a dynamic blend of equity, debt and hybrid funds. However, finding the right mutual funds can feel like searching for a needle in a haystack.
Why might an investor not want to use a mutual fund? ›
Potential for loss: Mutual funds are not FDIC insured and may lose principal and fluctuate in value. Cost: A mutual fund may incur sales charges either up-front or on the back end that are passed on to the investors. In addition, some mutual funds can have high management fees.
Is it better to buy individual stocks or mutual funds? ›
For many investors, it can make sense to use mutual funds for a long-term retirement portfolio, where diversification and reduced risk are important. For those hoping to capture value and potential growth, individual stocks offer a way to boost returns, but come with more volatility.
Why are mutual funds a rip-off? ›
However, mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high expense ratios charged by the fund, various hidden front-end and back-end load charges, lack of control over investment decisions, and diluted returns.
What is the first step in choosing a stock to invest in? ›
Determine Your Goals. The first step to picking investments is determining the purpose of your portfolio. Everyone's purpose for investing is to make money, but investors may be focused on generating an income supplement during retirement, on preserving their wealth, or on capital appreciation.
Is it better to invest directly or in mutual funds? ›
Direct mutual funds typically have a higher NAV due to their lower expense ratio. This lower expense ratio in direct funds allows a larger portion of your investment to actively generate returns, potentially leading to higher overall returns compared to regular funds with higher expense ratios.
Why is it so important to avoid buying single stocks and invest in mutual funds instead Quizlet? ›
Why is it so important to avoid buying single stocks and invest in mutual funds instead? If that single company fails then you will not get that money back. With diversification you have less risk.
Is buying a single company stock safer than a stock mutual fund? ›
In general, investing in a stock mutual fund is less risky than investing in a single stock because mutual funds offer a way to diversify. Diversification means spreading your risk by spreading your investments. With a single stock, all your eggs are in one basket. If the price falls when you sell, you lose money.
Why is it less risky to invest in a mutual fund and stocks alone? ›
Mutual funds offer the investors the advantages of professional management and diversification. Diversification means that your investment risk is spread out. In addition, because your fund buys and sells larger blocks of securities at one time, its costs are lower than those typically paid by an individual.
