Tuesday, July 31, 2007

Mutual Funds vs. Individual Stocks

The vast majority of people should invest in mutual funds. Essentially, a mutual fund is a conglomeration of various stocks, and/or bonds, and cash. It is funded by many investors pooling their money together and rely on the expertise of a professional mutual fund manager who with a team of analysts manage the investments. They determine which stocks will be invested in and when the appropriate time is to buy, sell, or hold a stock.

The mutual fund manager and his or her analysts spend a great deal of time researching various companies and staying up to date on news surrounding them, financial reports, and market trends. These guys are major financial nerds who live and breath numbers.

Another major reason that mutual funds are a good option is the concept of diversification. Most mutual funds will hold at least 30 different stocks all the way up to index funds such as the Vanguard 500 fund which emulates the movement of the 500 companies in the S&P 500. This broad base of stocks spreads risk amongst many different companies so that if an example such as what occurred with Enron, the effect to the fund would be minimal.

When investing in individual stocks, a high degree of risk is present. A company may come out with poor earnings, encounter a major lawsuit, or their industry turns sour, and the stock price plummets. The investor may see any gains made quickly erased. By the same token, positive results may occur for the company and the stock price will sky rocket.

The only reason a person should ever invest in an individual stock is if he or she thinks that he can beat the return on a mutual fund. This implies special knowledge about the company which the rest of the market may not be aware of. It doesn't necessarily refer to insider trading but if he or she knows something about a company, chances are that some of those financial nerds at the mutual fund do too. Remember, those guys do it for a living. They have a vested interest in making good picks.

If a person insists on investing in an individual stock, he or she must be disciplined to spend significant time researching the stock before purchasing as well as while holding the stock. News comes out on a regular basis which can dramatically affect the price of a stock and so it behooves the investor to stay well informed on the health of the company in which their invested.

Mutual funds don't sound especially exciting but over a long term (5-10 years) consistently perform well. Gains of 12% can be expected if looking at a good fund over a long period of time. An investor should research the track record of a fund and select one which lines up with his or her goals (there are many different types of funds such as growth, value, index, aggressive, international, small cap, blue chip, etc.) He or she would likely want to invest money into several types of funds as well which will add further diversification.

Mutual funds provide a solid investment vehicle which offer great returns over a number of years. While great gains can be made with individual stocks, great losses can also be incurred. The risk along with the significant knowledge gap and time the individual has versus professional money managers should give significant pause and nearly always tip the scale in favor of investing in mutual funds.

No comments:

Related Posts Plugin for WordPress, Blogger...