Why prefer a mutual fund instead of stocks? Key differences explained

Many investors starting their financial journey find themselves in a dilemma – whether to invest in mutual funds or stocks? Investing is an essential step towards financial growth, but choosing a suitable investment option can be confusing. While stocks offer direct ownership in a company, mutual funds pool money from different investors to invest in a diversified portfolio. Each option has its own advantages and risks and the choice depends on an individual's financial goals, risk tolerance and investment knowledge.

This article will explain why many people prefer mutual funds over stocks by covering key differences, risk factors, benefits and convenience.

• Table of contents

1. Mutual funds: The basics
2. Mutual funds vs stocks
3. Mutual funds offer lower risk
4. Advantages of mutual funds
5. Diversification of mutual funds
6. Mutual funds vs. stocks: The convenience factor
7. Cost differences between mutual funds and stocks

Mutual funds: The basics

Mutual funds are investment vehicles that pool money from various investors to buy a diversified portfolio of stocks, bonds, or other assets. These funds are managed by professional fund managers who make investment decisions on behalf of investors. Here are some salient features of Mutual Funds:

• Professional management: A fund manager makes decisions about buying and selling investments.
• Diversification: Funds invest in multiple securities, relatively reducing the risk of losses.
• Liquidity: Open ended mutual funds can be bought or sold at their net asset value (NAV) at the end of each trading day.
• Accessibility: Investors can start with a small amount and gradually increase their investments.

Mutual funds vs stocks

Ownership

• Stocks: When you buy a stock, you become a partial owner of a company.
• Mutual funds: You do not own individual stocks but rather a portion of a professionally managed fund.

Risk factor

• Stocks: Can be highly volatile, with prices fluctuating based on market conditions.
• Mutual funds: Spread risk across multiple assets, mitigating overall risk.

Investment knowledge required

• Stocks: Require in-depth research and market analysis.
• Mutual funds: Managed by professionals, making it easier for beginners.

Diversification

• Stocks: Requires buying multiple stocks for diversification, which can be expensive and laborious.
• Mutual funds: Automatically diversified across different companies and industries.

Time commitment

• Stocks: Requires constant monitoring and decision-making.
• Mutual funds: Less time-consuming as fund managers handle investments.

Mutual funds offer relatively lower risk

One of the biggest reasons investors prefer mutual funds over stocks is relatively lower risk. Since mutual funds invest in multiple assets, they are not entirely dependent on the performance of a single company. If one stock in the portfolio underperforms, other stocks can balance the losses. This built-in diversification makes mutual funds a relatively more stable option for conservative investors. And the reason why mutual funds have lower risk:

• Diversification reduces individual stock risk.
• Professional fund managers make informed investment decisions.
• Investment in bonds and fixed-income assets provides stability.

Advantages of mutual funds

Professional management: Mutual funds are managed by financial experts who analyse market trends and adjust portfolios accordingly. This is beneficial for individuals who lack investment expertise.

Automatic diversification: Instead of putting all money into a single stock, mutual funds spread investments across multiple companies and sectors.

Lower cost for small investors: Investing in multiple stocks individually may require significant capital. With mutual funds, investors can start with small amounts while still enjoying a diversified portfolio.

Liquidity: Mutual funds can be bought or sold easily, ensuring that investors have access to their money when needed.

Systematic investment plan (SIP) option: Mutual funds allow investors to invest small amounts regularly, making investing more affordable and structured.

Diversification of mutual funds

Diversification is one of the main benefits of investing in mutual funds. Instead of relying on the performance of a single stock, investors gain exposure to a variety of assets, such as:

• Different sectors such as technology, healthcare, finance
• Various asset classes such as stocks, bonds, gold
• Global investments (some funds invest in international markets)

Mutual funds vs. stocks: The convenience factor

• No need for deep market knowledge: Professional fund managers handle stock selection and investment strategies.
• Less time-consuming: No need to track daily stock market movements.
• Easy to invest: Can be started with small amounts and increased over time.
• Automated investments: Many mutual funds offer SIPs, automating the investment process.
• Tax benefits: Some mutual funds, such as Equity Linked Savings Schemes (ELSS), provide tax benefits under Section 80C of the Income Tax Act, 1961, under the old regime.

Cost differences between mutual funds and stocks

Transaction costs

• Stocks: Buying and selling stocks involve brokerage fees and other charges.
• Mutual funds: Typically have lower transaction costs due to economies of scale.

Management fees

• Stocks: No management fees, but investors must conduct their own research.
• Mutual funds: Include management fees for professional handling of investments.

Minimum investment requirement

• Stocks: Buying multiple stocks for diversification requires significant capital.
• Mutual funds: Investors can start with as little as Rs. 500 in general through SIPs.

Conclusion

Mutual funds provide a balanced and convenient investment option for individuals looking to potentially grow their wealth without the complexity of picking individual stocks. Their built-in diversification, professional management, and ease of investment make mutual funds a suitable choice for both new and experienced investors. While stocks may offer a higher return potential, they come with greater risks and require extensive market knowledge. For those seeking relatively lower risk and professional management, mutual funds remain the preferred choice.

FAQs:

Are mutual funds safer than stocks?

Yes, mutual funds are relatively stable than stocks because they are diversified. Unlike stocks, where the performance of one company can greatly impact an investor's returns, mutual funds invest in multiple securities to mitigate risk.

What are the basics of mutual funds?

Mutual funds collect money from multiple investors and invest in a diversified portfolio of stocks, bonds, or other securities. Professional fund managers handle investment decisions, and investors receive units proportional to their investments.

What is the difference between mutual funds and stocks?

Stocks represent ownership in a company, while mutual funds are pooled investment vehicles managed by professionals. Stocks require active monitoring, while mutual funds provide diversification and relatively lower risk.

What are the advantages of mutual funds?

Mutual funds offer diversification, professional management, affordability, liquidity, and systematic investment options, making them ideal for beginners and long-term investors.

How does diversification work in mutual funds?

Mutual funds invest in a mix of stocks, bonds, and other securities across various sectors, reducing the impact of poor performance from any single investment. This strategy helps stabilise returns and mitigates risks.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.