If I want to invest in stocks, should I invest directly in individual stocks, or use equity mutual funds instead? And what factors should I consider when making my choice?
The biggest factor to consider is diversification. If you invest directly in stocks, you would invest in 5, 10, maybe 20 individual stocks at most. This means that your investment is solely in those stocks, and therefore, your risk increases.
Against this, if you invest in an equity mutual fund, you are investing in a large group of stocks – and if it is a broad based fund like an S&P 500 fund, you would be investing in 100s of stocks. This means that your investment is diversified, and your risk reduces.
That sounds good. But is there any downside to this?
Yes. You know the relationship between risk and return: the higher the risk of an investment, the higher the potential return.
So, an investment made in individual stocks has the potential to provide a much higher return than an investment made in equity mutual funds. On the flip side, an investment made in individual stocks also has a way higher potential of providing a negative return – or losing money.
For example, if you had invested in Amazon stock 10 years back, you would have received a return of Two Thousand Four Hundred Percent. Whereas if you had invested in Nokia or Kodak stock 10 years back, you would have lost almost all your money by today.
Against this, an investment in diversified equity mutual funds would have provided an average return of 10-12% per year, or around a 180% gain over the 10 year period.
Wow, that’s interesting! Is there anything else I should consider when deciding between these two approaches?
One more thing you need to consider is the minimum amount of money required. Some large-cap stocks cost thousands of dollars, which means you would need a minimum of that much to invest in just one stock of that one company! Even if you’re buying stocks that are priced lower, you would still need a large amount to invest directly in individual stocks and create a portfolio. Against this, you can start investing in mutual funds with as little as a couple hundred dollars.
Another factor is the recurring expense – when you buy mutual funds, you pay a certain percentage of the value of your investment as fees. Depending on the type of mutual fund, this could be anywhere from 0.05% to 3 or 4 percent, which reduces your return by that much. On the other hand, a direct purchase of stocks does not have any such ongoing expense.
So would you recommend investing directly in individual stocks, or investing in equity mutual funds?
For someone just starting out with equity investment, investing in equity mutual funds would be better.
Investing in index funds, like S&P 500 based index funds, would be an ideal approach since it provides a good balance of diversification, low expense ratio, and predictable returns over the long term.