Which is Better: Stocks or Mutual Funds?

Almost all financial advisers recommend you have at least some of your money in the stock market. For investors who follow that advice, one major question is whether investing in mutual funds makes more sense than purchasing stocks individually.

There's no simple answer, and you may even want to hold both individual stocks and mutual funds. "That tends to be what I've done," says Mick Heyman, an independent financial adviser in San Diego. "I might have core index funds consisting of small-cap, large-cap and international stocks and then around that I'll own a portfolio of 25 to 30 individual stocks."

Diversification, fees and taxes constitute some of the issues you'll want to take into account when making your decision.

A mutual fund provides instant diversification. "Most funds will hold at least 20 stocks, and many hold more than 50," says Chris Larkins, a senior investment adviser at HPM Partners in Cleveland. "You can invest in small or large increments. That can be cost-efficient."

If you want to achieve diversification through individual stocks, many advisers say you need to buy at least 20 different names. And you'll probably want to put at least $5,000 in each stock, though you can go as low at $1,500 to $2,000 if you're trading through a discount brokerage, which will generally charge you about $8 per trade.

If you want exposure to foreign stocks, it's much easier to do so by investing in mutual funds, as most foreign stocks aren't easy to buy individually.

Hiring a Manager vs. Being a Manager

Investing in a mutual fund also gives you a manager who is constantly watching over the portfolio. "We like being able to rely on someone else's expertise for buying and selling," says Diane Pearson, a shareholder at Legend Financial Advisors in Pittsburgh. "You're hiring a manager to make decisions on timing and allocations."

Buying individual stocks means you have to learn about companies on your own. "It takes time and acumen to research companies, track them and buy a portfolio that's well-diversified," Larkins says. Deciding when to sell can be a difficult issue, too.

And you have to pay attention to whether big gains in some stocks are overweighting you in those sectors or whether big losses in other stocks are underweighting you in those sectors.

But if you want control over exactly when you'll buy and sell your stocks, you're obviously better off going the individual stock route. That also gives you control over when to take a capital loss or a capital gain, which has implications for your taxes.

When investing in mutual funds, you don't know when the managers will decide to take capital gains, which means tax payments for you. And it can even happen in years when a fund produces a negative total return.

If you want to know exactly what you're holding all the time, you'll also want individual stocks, as mutual funds aren't required to reveal their portfolio more than a few times a year.

Managers Move Around

Another potential issue with mutual funds, particularly ones that belong to large families of funds, is that you don't know how long the manager will stay in place. Fund managers can be fired or transferred to other funds within the family, or they can move to a new company on their own.

Then there's the issue of fees. Annual mutual fund fees generally range from 0.2% to 2.5%, with actively managed funds averaging 1.3% and index funds selling for 0.76% on average, according to Morningstar, an independent investment research company based in Chicago. In addition, some funds charge a fee when you buy shares -- a front-end load. And some funds charge a back-end load if you sell before holding the fund for a defined period.

If you buy individual stocks through a discount brokerage, you can keep your expenses quite low if you aren't an active trader. "Fees can be less for individual stocks if you're a buy-and-hold investor," Larkins says.

Actively managed mutual funds not only charge the highest fees, but a majority of them underperform major market indices. So Heyman says if you go the mutual fund route, choose index funds. Those funds give you more certainty as to what their holdings are, and their returns should closely match the benchmark they follow.