Over the past three decades, mutual funds have become a popular investment vehicle for the average person. However, the majority of those who invest in them often have limited knowledge as to what they actually are. They may know that investing in a mutual fund exposes them to the stock market, but they have little understanding with regard to the potential risk that is involved. That is until the stock market takes a tumble and they see their account values plummet.
When it comes to individual stocks and how they relate to the mutual fund investor, the explanation is anything but simple and a quick read through a Stock Market For Dummies book might be advised. The dilemma that many investors become enthralled with has to do with the advantages of purchasing shares of individual stocks or buying mutual fund shares.
One of the primary reasons that mutual funds have dramatically increased in popularity is directly related to the underlying investments of 401(k) participants. Anyone investing in their employers 401(k) plans generally have a few investments options to choose from. During that annual company meeting where the retirement benefits are explained, the historical performance data of the investments found within the 401(k) are highlighted. Generally, mutual funds fare much better than the other investment choices found within the plan. Many employers also provide a match to any employee participating in the 401(k), which makes many employees feel compelled to join up. Thus, a mutual fund investor is created.
Mutual funds are open ended investments that invest in individual stocks, bonds, certificates of deposit, real estate and money markets. These funds are usually managed a team of professionals that are employed by the mutual fund company. Individual stocks within a mutual fund are purchased to match the focus of the fund itself.
There are lots of different fund you can buy that have different goals or criteria. Growth funds purchase large amounts of individual stocks that have a high potential for growth. Whereas, growth and income funds contain various issues of stocks that have dividends that provide income as well as growth. There are funds that focus in on geographic or specific business and technological sectors. Some mutual funds may have over 100 different individual stock issues contained within it’s portfolio.
One of the greatest considerations within managed mutual funds is called turnover. This is the frequency in which the fund’s underlying portfolio is bought and sold within any given year. High turnover with profit can create a higher tax liability. This is a huge consideration when buying shares of mutual funds because it can undercut the net profit of the investor.
The most frequently questioned consideration of most mutual funds is their often excessive expense ratios. This along with turnover can make investing in aggressively managed growth funds unattractive, especially in a down market.
Individual stocks are often considered during both bull markets and bear markets. When the bulls are running and the market is high, new issues of stock also known as “hot issues” are created with impunity. Many individual stock investors jump on these risky bandwagons with religious fervor. The end result can be huge losses in the blink of an eye.
However, purchasing individual stocks during down markets can be profitable over the longer term. This is known as value investing, which is something that has grown in popularity since the peak of the recession. However, investing in any individual stock limits the diversity found within the mutual fund world. The risk of buying individual issues over the potential to purchase many may be a concern to the average investor.
For the 401(k) investor, individual stocks are usually not available within the plan itself. Therefore, exposure to individual stocks would likely come outside of the retirement world. However, IRAs and Roth IRAs are easily set up to accommodate the purchase of individual stocks. The biggest problem with buying individual stocks is that the average investor must actively manage his or her own portfolio. Though there are brokers who will gladly perform this task for a commission, it is still up to the investor to express their own personal goals for profit and success. Buying individual stocks means that the investor must make the correct choices twice. Buying low and selling high is definitely not as easy as it may seem.