New investors often ask themselves whether they would be better off investing in funds or individual stocks. With the vast amount of mutual funds, ETFs and index funds available it’s understandable that some people have a hard time deciding where to begin. This post is going to cover the difference between these funds, and the pros and cons of investing in a fund instead of picking individual stocks.
A mutual fund is a professionally managed portfolio of stocks, bonds, or other securities. The main benefit of mutual funds is they give individual investors access to a professionally managed investment portfolio. They usually charge fees for this service, and most employer-sponsored retirement plans go into mutual funds. The individual(s) that manage a mutual fund also try to actively outperform the market. Mutual funds can usually be bought or sold at the end of each trading day.
An exchange traded fund (ETF) is also a collection of stocks, bonds, or other securities that is very similar to a mutual fund. The main difference between the two is ETFs shares are traded on an exchange, which means they can be traded throughout the day just like individual stocks. They are also usually passively managed, so the fees associated with them are typically lower.
Finally we have index funds. An index fund can be a mutual fund or an ETF that contains a collection of securities to track the components of a financial market index, such as the Nasdaq Composite Index. Index funds typically seek market-average returns, and their performance is relatively predictable over time. An example of a mutual fund that is also an index fund would be the Fidelity 500 Index Fund (FXAIX), and an example of an ETF that is also an index fund would be the SPDR S&P 500 ETF Trust (SPY).
When deciding to go with a mutual fund or an ETF it’s important to do your homework. As an example, let’s take a look at the two funds I just mentioned. Typically I would expect a mutual fund to have higher fees and outperform an ETF, however that isn’t always what happens. In this case if you look at SPY on morningstar, you can see it actually has outperformed FXAIX so far this year as of the date this post was published. To make matters even more confusing, SPY actually has a higher expense ratio (.095% vs. .015% for FXAIX).
This brings up a point that many other investors have already figured out, which is that ETFs often actually outperform mutual funds. In this particular case I’m not going to say that one of these funds is better than the other (they are both very good and index funds), but if you look into it more you can find other examples of ETFs outperforming mutual funds.
In terms of deciding to invest in individual stocks or funds I would argue you should start out with funds and then slowly start investing in individual stocks after you’ve done your homework on them. Picking individual stocks that outperform the market is not as easy as most people think it is, and an article posted on NPR a couple of days ago came to the same conclusion:
It’s too difficult to pick stocks that will be winners. Even professionals at mutual funds usually can’t do it well enough to justify the fees they charge you. Around 85-90% of the time they fail to outperform the market over time.Arnold, Chris. “GameStop Mania Likely Won’t Happen Again. Here’s How To Invest Wisely” NPR, 5 Feb 2021. https://www.npr.org/2021/02/05/963787901/gamestop-mania-likely-wont-happen-again-heres-how-to-invest-wisely.
Having said that I’ve decided to invest individual stocks with my Roth IRA for the time being and I suppose we will see how it goes. I realize I’m basically saying you would probably be better off doing as I say and not as I do, but I like researching individual stocks and putting everything into funds seems boring to me. I’ve also spent a significant amount of time researching the stocks I’m planning on buying, and at this point I think I’ve identified some really great companies and that there is a good chance they will outperform the overall market. Time will tell if I’m making the right decision.