From a purely functional standpoint, stocks are a pretty straightforward proposition, relative to mutual funds. You have certainly heard somebody boast about a stock tip; mutual funds simply don't carry the same cultural weight. Just because they are more familiar, however, stocks are not necessarily a better investment choice than mutual funds. As with any other financial decision, you need to look at the bigger picture and weigh the pros and cons.
Shares of stock represent an ownership stake you have in the company that issues the stock. While a mutual fund can contain stocks, this is not always the case. As the U.S. Securities and Exchange Commission explains, mutual funds collect money from investors and seek a return by investing that cash in investments ranging from stocks and bonds to commodities and money markets.
Generally speaking, mutual funds provide better diversification for an investment portfolio than stocks do. The U.S. Securities and Exchange Commission contends that "some investors" have an easier time spreading their investments over a wider range of possibilities -- not "putting all of their eggs on one basket" -- by choosing mutual funds over individual stocks. For example, if you are a small investor, you might not have the resources -- particularly money, time and know-how -- to put together a stock portfolio that mitigates risk by investing in several sectors of the economy, companies of various sizes and different regions of the world. You can, however, realistically achieve diversification by selecting a small number of mutual funds.
For most investors, taxes are a going concern. Owning individual stocks gives you greater control, not only when it comes to selecting where to direct your money, but in minimizing your tax liability. When you own a mutual fund, the fund's manager makes the key tax decisions, such as when to buy and sell stocks. If the manager sells a stock for a profit this produces a taxable capital gain. If she owns stocks that pay dividends, this is also a taxable event. When a mutual fund realizes capital gains and dividends, it pays out a distribution to its shareholders. You must report these annually to the IRS, unless you own the fund inside an IRA. SmartMoney magazine advises selecting tax-friendly mutual funds to ameliorate this lack of control. Some "tax-managed" funds, for example, limit portfolio turnover, which refers to the frequency with which the fund trades its investments.
While individual stocks can generate capital gains and dividends, other than trading commissions, they generally don't carry with them attendant fees. Mutual funds do. All funds have an expense ratio, which is a percentage of your investment you pay to cover the mutual fund's overhead. Some mutual funds charge additional fees, such as sales loads and redemption fees. A sales load can occur when you initially invest in a fund or when you cash it. In either case, funds can charge a percentage of up to 8.5 percent of your investment as a sales load to pay outside brokers who offer the funds to their clients. A redemption fee, as the U.S. Securities and Exchange Commission notes, pays other costs associated with running a mutual fund and cannot exceed 2 percent. As the name implies, you pay the redemption fee when you cash out shares of a mutual fund.
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