Investing in individual stocks* is an option for your portfolio. However, investing in stocks involves a lot of diligence, research, and discipline. Many of us don’t have the time, money, or fortitude to carry through with an investment plan that includes individual stocks.
Additionally, stock picking can lead to additional stress if you find yourself constantly (daily) looking at your stocks and worrying if you should buy, sell, or hold. If you think you’re the type of person who could unemotionally buy and sell stocks for your portfolio and remain consistent in doing so, then you may be the rare investor where this could be a viable option.
Building a portfolio of stocks also means you must purchase enough stocks – and enough different types of stocks – to have adequate diversification to reduce your risk compared to owning just one or a few companies. This can be difficult to do if your money is limited or the prices of the companies you’ve researched are out of your budget (e.g. as of this writing, Berkshire Hathaway A shares are trading at just over $300,000 per share).
Here’s where investing in mutual funds and ETFs (exchange traded funds) can be beneficial. Some of the advantages of investing in mutual funds or ETFs include instant diversification, economies of scale, professional management, and (generally) lower expenses.
Instant Diversification – Unlike investing in several single stocks to achieve diversification, purchasing just one share of a mutual fund or ETF gives you expose to hundreds, if not thousands of different companies.
Depending on the goal of the fund (large, medium, or small company, US, international, bond, etc.) it will hold a sample of the companies that make up the investment allocation the fund is trying to achieve.
Let’s say you want to invest in the S&P 500 – an index of roughly 500 larger US companies. Purchasing a fund replicating the S&P 500 would get you access to over 500 companies with only one share! The same would be true for a bond fund, international fund; you get the point.
Economies of Scale – This means that by using mutual funds or ETFs allows you to have access to many companies for less than the cost of purchasing them separately. Looking at our S&P 500 example, an investor purchasing individual stocks would have to buy over 500 different stocks to replicate this index. Very expensive to do.
Buy purchasing a mutual fund or ETF replicating the S&P 500, the investor gets exposure to over 500 companies, with only 1 share of the fund, for substantially less money.
Professional Management – Investing in mutual funds or ETFs gives you access to professional money managers whose job it is to monitor the portfolio of stocks so you don’t have to. Often fund managers have extensive experience, education, and certifications that qualify them to manage the fund(s) they oversee. The alleviates you from the stress of constantly looking at your investments (which you shouldn’t do anyway).
Depending on the type of fund (actively versus passively managed), the fund may have more than one manager and may have more expenses due to the goal of the fund (e.g. funds that try to beat the market typically charge more).
Lower Expenses – In many cases investing in mutual funds or ETFs carries lower expenses. In additional to requiring less money to invest in more companies, choosing lower expense funds means that more of your money is working for you. You should consider looking for funds that have expense ratios of .5% (one-half of 1 percent) or less. This should be easy to do by choosing index mutual funds or ETFs.
*Or individual bonds