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Individual Stocks or Mutual Funds... Which Are Best for Me?

Part II of a series about investing your money

Previously in this series: Sally and Matt are cousins. Their grandfather, Bert, just gave each of them a great present...$3,000! But Grandpa Bert has attached some "strings" to the gift—they can't spend the money for 10 years, they have to learn about investing the money, and they have to discuss what they've learned with him. Both Sally and Matt have another $800 they've saved from their after school jobs that they're going to add to Grandpa Bert's gift, so they're each working with a total of $3,800.

A choice of methods

To get Sally and Matt started, Grandpa Bert tells them that people who keep their money invested in stocks over the long-term generally earn higher returns than if they keep the money in the bank or invest in bonds.

Sally and Matt do some homework and find that their 10-year holding period is considered a long-term period, so it makes sense for them to invest in stocks.

But how? Sally and Matt have heard a lot about mutual funds. Should they invest in a mutual fund? Should they buy individual stocks?

When talking about stocks, long-term is at least 10 years.

Grandpa Bert suggests that Sally learn about investing in stocks, and Matt learn about investing in mutual funds. Since there are some important differences between the two methods, they'll be able to compare their results and discuss which approach is right for them.

Matt tackles mutual funds

Just call him 'Mutual Matt.'
Mat tackles mutual funds.

Matt first learns that mutual funds are pools of money run by professionals who select stocks or bonds and buy them for the fund. Mutual funds generally contain hundreds or thousands of individual stocks and/or bonds at any one time.

To invest in a mutual fund, a person buys shares of the fund, which adds to the pool of money available for investment. People can think of mutual fund shares as representing a fraction of each stock or bond the fund holds.

Matt looks at the costs involved with mutual funds next. He discovers that mutual funds charge several fees. The total amount of these fees can vary from a fraction of a percent of the amount invested to several percent of the amount invested per year.

The SEC is responsible for protecting investors.

The Securities and Exchange Commission (SEC) is the federal agency responsible for protecting investors and making sure the securities markets are fair. The SEC has created an on-line calculator to help people sort through the various fees mutual funds charge, and decide which fee structure would be the best for them.

Matt visits the SEC Web site to access a mutual fund fee calculator.

Sally takes stock of stocks

Call her  'Sally Stocks.'
Sally takes stock of stocks.

At the same time, Sally looks into investing in individual stocks and learns that people do this through accounts with brokerage firms.

An investor opens an account by filling out forms and depositing money into the account. Investors typically must be at least 18 years old to open an account while younger investors need to have a parent or guardian open a custodial account for them.

After the investor opens the account, he tells a broker at the firm what stocks he wants to buy or sell, and the broker carries out the order.

Sally learns that there are different types of brokerage firms: firms are generally known as either discount brokers or full-service brokers. After contacting several firms of each kind, Sally realizes that discount brokers generally charge lower fees, but offer investors fewer services.

Sally asks about the kinds of fees brokerage firms charge. She discovers that firms charge annual account fees as well as fees called commissions.

Learn more about mutual fund fees.

Sally finds that there are a lot of differences in the ways that brokerage firms charge fees:

Sally learns that it is important to ask questions and shop around.

Those pesky fees

Sally and Matt come back to Grandpa Bert and tell him what they have found. When they compare the fees that mutual funds charge and the fees that brokerage firms charge, they see that the costs of investing in mutual funds are sometimes higher than the cost of investing in individual stocks through a brokerage account, especially if the firm is a discount broker.

Over time fees can significantly reduce returns.

Matt also shares some research he's done about how costs affect the returns an investment earns. He tells Sally and Grandpa Bert that even if costs such as fees seem small in any one year, they can really add up over time and significantly reduce long-term returns.

Why would someone invest through a mutual fund if it costs more? Grandpa Bert explains to the cousins that there is more to it.

Mutual funds offer several features that are very important to some investors: for those people, the fees mutual funds charge may be well worth it. After talking it over with Grandpa Bert, Sally and Matt see that they have more work to do!

Time and time again

The next topic Grandpa Bert suggests they look into is the time necessary to manage their investments. Matt learns that one important feature mutual funds offer is professional management.

By investing in a mutual fund, an investor hires the mutual fund company to pick stocks and to decide when to buy them and sell them.

Increasing over time is the goal.
IIt takes time to choose a mutual fund.

But Matt also learns that choosing a mutual fund takes time because investors should consider many things before making their decisions. The SEC recommends that investors consider items such as:

Matt realizes that after investing in a mutual fund, it's important to keep track of how the fund is doing.

Meanwhile, Sally is busy learning that investing in individual stocks also takes a lot of time. Investors have to learn how to research individual stocks, do the research, and keep track of the stocks they buy.

Sally tells Matt and Grandpa Bert that investors who can't take this time are better off hiring a mutual fund company to do the work.

Spreading your risk

Next, Matt and Sally share what they'd learned about another investment concept: diversification.

There are thousands of mutual funds—not all are diversified—but Matt knows that many mutual funds are diversified. By investing in one of these funds, Matt would instantly diversify his $3,800.

Diversification requires 12 or more stocks.

Sally tells Matt and Grandpa Bert about a study showing that investors need to own at least 12 separate, carefully selected stocks to be diversified. They all realize that if Sally wants to invest in this many stocks, she's got a lot of work to do.

They also see that it's not realistic for Sally to try to split up her $3,800 among 12 or more stocks.

Decision time

Sally and Matt now have a decision to make... Are individual stocks or mutual funds right for them? They've both really enjoyed learning about these two kinds of investments. They realize that by investing in individual stocks, their $3,800 would probably not be as diversified as it would be if they invest through mutual funds.

But after thinking carefully about their choices and discussing it with Grandpa Bert, they decide that they would probably learn more about stocks and the economy by investing in individual stocks. So their choice is to invest in individual stocks!

In the next article in this series, we'll begin to learn about how to analyze individual stocks along with Sally and Matt.

By Richard Entenmann

Note: References to publications, products and/or services are not endorsements, and not meant to exclude others that may be similar. Examples are merely a convenience to the reader. 

True or False: One of Benjamin Franklin's invention includes a glass harmonica that was used by such musicians as Mozart and Beethoven. Click Ben's head for the answer.
TRUE: Franklin called the instrument the 'armonica.' He invented it in 1761.
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