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When to Choose Between Mutual Funds vs. Stocks

Ellen Chang

Unlike stocks, mutual funds offer built-in diversification and combine buckets of money for people to invest in stocks and bonds and are often recommended by financial advisors to include in a portfolio.

Actively managed mutual funds and index funds remain popular assets for investors socking away their money in retirement portfolios. These assets are less risky and younger investors often add them to a 401(k) or brokerage account, since small amounts of money can be invested in them.

Choosing the right stocks can be tricky and time-consuming since there is more volatility.

"The economies of scale that come with mutual funds will always beat stock picking for 99.9% of investors out there," says Derek Horstmeyer, an assistant professor of finance at George Mason University in Fairfax, Va.

Here are a few things to know about how mutual funds differ from stocks in your portfolio:

-- Mutual funds provide diversification.

-- Mutual funds can lack transparency.

-- Expense ratios in mutual funds can be expensive.

-- Investors can lose their entire investment in stocks.

Mutual Funds Provide Diversification

Mutual funds can hold thousands of stocks and can help take a bit of the guesswork out of investing, says Rich Messina, senior vice president of investment product management of E-Trade, a New York-based brokerage company. The goal of mutual funds is to beat the market through a "collection of selected stocks managed by a professional who is accountable for the fund's performance," he says.

No amount of fundamental analysis and research done on individual stocks will beat what mutual funds are offering now for 99% of investors, says Horstmeyer.

[See: 9 ETFs to Invest in Solid Alternative Assets.]

Mutual funds give investors access to specific segments of the capital markets such as consumer goods or energy, says Chris Osmond, chief investment officer at Prime Capital Investment Advisors.

Without a large amount of capital, an investor could have difficulty achieving enough diversification if only a handful of stocks were purchased, he says.

In asset classes such as small-cap U.S. equities, emerging markets equities and even high-yield bonds, it's very difficult for investors to gain adequate diversification when choosing individual securities, Osmond says.

"Even wealthy investors can benefit from mutual funds," he says.

Mutual Funds Can Lack Transparency

The holdings of mutual funds are not disclosed in real time, making it harder for investors to know whether to reallocate or divest their assets.

"The level of transparency comes into play," Messina says. "It comes down to your investing philosophy if you're okay not knowing what makes the engine run."

The major drawback of investing in mutual funds is that investors don't actually own the underlying stocks in a fund because the mutual fund owns the stock, says Osmond.

Another issue is that investors have no control over which stocks are purchased and owned in the mutual fund.

The desire to own investments that are aligned with an investor's moral compass is growing in popularity, resulting in more assets being invested in sustainable investing and environmental, social and governance, known as ESG, he says. An investor who is not a fan of Facebook ( FB) would own shares of the company indirectly because it is the fourth-largest holding in the T. Rowe Price Institutional Large Cap Growth Fund ( TRLGX), for example.

[See: 6 Investing Podcasts Advisors Recommend.]

Mutual Funds Can Be Expensive

All mutual funds charge expense ratios, which is the annual cost to run the fund. An investor who allocates $10,000 annually in a mutual fund that carries an expense ratio of 0.2% will pay $20 in fees.

"Some funds are expensive and as with any investment, there is no guarantee they'll achieve outsized performance," Messina says.

Mutual fund fees are higher than index funds because the assets are bought and sold by a portfolio manager. The costs of a mutual fund can be as high as 1.5% per year or more, says Gary Lemon, a professor of economics and management at DePauw University. Investors who buy an index fund typically will only pay 0.04% or lower.

While mutual funds offer different levels of diversification, they can be more expensive than purchasing individual stocks, Osmond says. TRLGX, which invests in large U.S. growth companies carries an internal expense ratio of 0.56% for its institutional share class.

"Pay close attention to the share class as active mutual funds have various costs that vary with the share class," he says. "Institutional share classes are typically the lowest cost share class a mutual fund provider will offer retail investors."

Stocks Can Be Risky

Owning individual stocks give an investor more control in buying and selling shares and managing a portfolio, says Stuart Michelson, a finance professor at Stetson University. The costs with owning stocks can range from no fees to a nominal fee of $5 a trade and is cheaper than owning mutual funds. But investors tend to speculate more in individual stocks, creating more risk, he says.

An investor becomes part owner of a company after buying shares, Messina says.

"But this is what can make owning individual securities exhilarating -- you truly have skin in the game when it comes to the future of the company," he says.

Despite a higher level of risk, stocks do provide investors with a sense of connection to a specific industry, brand, company or management team that isn't possible when investing in a mutual fund, says Henry Yoshida, CEO of Rocket Dollar, an Austin, Texas-based self-directed individual retirement account and solo 401(k) provider.

"For a portion of an investor's portfolio, it is empowering to own a direct piece of a company because of your belief in their business, mission or leadership," he says.

Investors can run into problems if the stocks they own are volatile or have been declining for a prolonged period.

"If an investor only owns Stock A and it has a bad day in the market, the investor's portfolio could be dramatically affected," Messina says. "An index mutual fund would help mute some of the price swings that can come along with stocks."

Hitting a home run such as buying the next Apple ( APPL) or Amazon.com ( AMZN) and seeing the price of the stock double or triple can only occur with buying individual stocks, says Lemon.

[See: 8 Investing Do's and Don'ts During Market Volatility.]

"Hitting a home run is not going to happen with a mutual fund," he says.

Owning stocks mean being prepared for them to rise and fall with the broader stock market. In addition, a stock like General Electric ( GE) could also lose a major government contract which will cause the stock to suffer a loss outside of the general market.

"An investor can drastically reduce unsystematic risk by buying a diversified portfolio of stocks," he says.

Portfolio Strategy Is Important

Empirical evidence has shown that investors need to buy at least 15 stocks for lower unsystematic risk to acceptable levels, Lemon says.

The reduction of unsystematic risk after owning 30 stocks is negligible and investors do not need to own more than that amount. The risk can be eliminated by buying a mutual fund.

"This why a prudent investor will own between 15 and 30 stocks," he says.

Unlike ETFs and stocks, mutual fund prices settle at the end of each day, so the prices are not available in real time, Messina says. Portfolios should be rebalanced on a regular basis even if the investor owns several mutual funds.

"Even though a portfolio of mutual funds can do most of the heavy lifting for you, it's still important to check in on where you're most heavily invested as the market and portfolio managers can change with it," he says.

The same goes for stock investing -- if the market rallies in energy and an investor is overweight in the energy sector, a portfolio can wind up off-kilter.

The minimum investment for mutual funds is often $3,000. To create a diversified portfolio of stocks, an investor would have to allocate $60,000, Lemon says.

"If you buy a good mutual fund, you can make one decision and forget it," he says. "Buying a portfolio of stocks may require 30 decisions or one for each stock you buy, plus a constant review of these stocks," he says.

Having an allocation to both stocks and mutual funds is a viable strategy for an individual investor with a certain threshold of experience and asset level, Yoshida says.

"The funds can act as a ballast to ensure very broad diversification across thousands of investments and over a dozen different asset classes, while the individual stock investment part of your portfolio can allow an individual to over-allocate to a particular business where your personal conviction toward the business, the mission of the enterprise or the leadership team is high," he says.

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