This article was updated on June 5, 2017, and originally published July 17, 2015.
There are three main ways to invest in the stock market: You can buy individual stocks, mutual funds, and/or exchange-traded funds (ETFs). Because each has its own pros and cons, let's examine which approach is best for your portfolio.
Your three options
If you're reading this, I'm assuming you have a basic idea of what a stock is. However, beginners may not be familiar with the other options.
The general idea of a mutual fund is that many investors pool their money, and a manager then invests that money according to the specific fund's objectives. Some mutual funds track a certain index, like the S&P 500 (passively managed funds), and some follow an objective, such as "growth" (actively managed).
Exchange-traded funds, or ETFs, are similar to mutual funds in the sense that your money will be spread among many stocks, but there are some key differences to point out. For one thing, ETFs trade just like stocks on major exchanges. You can buy and sell your shares whenever you want, unlike mutual funds, whose shares must be redeemed. Another difference is that ETFs are mostly indexed (passive) -- few are actively managed.
Upside potential and downside risk
The main reason investors buy individual stocks is simple: if the company does well, it's possible to make lots of money. For example, if you had put $1,000 into Apple stock in 2002, your investment could be worth more than $174,000 today, including dividend reinvestment.
However, there are some things to keep in mind. Sure, stocks can produce massive gains, but they also carry more risk than mutual funds or ETFs. Just as Apple shareholders have been handsomely rewarded throughout the years, investors who owned shares of Radio Shack weren't so lucky. To sum it up, while you upside potential is more limited with funds than with individual stocks, you're probably not going to get wiped out either.
How much time do you want to spend on your investments?
Being a good stock investor requires time and discipline. You must be willing to spend the time to research potential stocks to buy, and you must have the discipline to buy stocks that are likely to make sound long-term investments.
Many investors choose funds for the peace of mind that comes with knowing an experienced professional chooses their stocks. Fund investors don't need to do any stock research or other ongoing homework. They simply invest and let the fund managers do the rest, and many investors feel that the time this saves more than justifies paying the management fees.
How much money do you have to invest?
To effectively invest in individual stocks, you need enough money to create a diversified portfolio of stocks (I usually suggest a minimum of 10), with a reasonable investment in each. If you invest small amounts, the brokerage commissions alone will eat away at your capital. My suggestion if you want to buy individual stocks is to plan on needing at least $10,000 to initially invest in at least 10 companies, so if one particular company tanks it doesn't have a devastating effect on your portfolio. If you're unable to do that right away, I'd recommend starting with mutual funds or ETFs.
One perk of investing in funds is that you get a diversified investment portfolio without investing much money. Through fund investing, you could have a diversified portfolio of U.S. stocks, foreign stocks, currencies, or commodities, while investing just a few hundred dollars. Many mutual funds have minimum investments of as little as $500 or $1,000 (and even lower if you set up automatic investments), and your money will be spread out over a large basket of stocks.
ETFs have no minimum investment (other than the cost of one share), but do incur trading commissions like individual stocks. So, an ETF investment should be large enough that the commission is justified.
Each option has different costs
I already mentioned commissions that come with stock and ETF trading, and these should definitely be taken into consideration. Online brokerages offer commissions typically ranging from $3.95 to $10.95 per trade, but it's worth doing some research, as the features you get from each brokerage vary.
With mutual funds, you'll pay a management fee that can eat into your gains, which you'll see listed as the expense ratio. For instance, if you invest in a mutual fund with 1% in annual fees, a 5% gain effectively becomes 4%. ETFs have management fees as well, but since these are mainly indexed investments, the fees tend to be relatively small.
Finally, it's worth mentioning that some ETFs and mutual funds do the exact same thing (like tracking a certain index), so investors should compare the fees and commissions of both options before deciding.
Stocks and ETFs can be tax-friendly in the sense that you don't have to pay taxes on your capital gains until you sell. With stocks, you can strategically choose when you want to take a taxable gain, or when to use a taxable loss.
Alternatively, the tax treatment of mutual funds is a potential negative. Capital gains are spread among all of the fund's investors, and there is no way of knowing when the fund will choose to sell its stocks. So, even if the fund has a losing year, investors could still be hit with a capital gains tax bill if the fund sold some of its stocks at a gain.
With all of these investments, you'll be subject to taxation on the dividends you receive, unless you invest in a tax-advantaged account like an IRA -- in which case you don't have to worry about taxes.
So, which should you choose?
Investors who are just getting started or don't have much money to invest right away may find mutual funds to be the more practical way to go, at least while they accumulate a bankroll and learn how to evaluate stocks.
Besides this, many of the differences are a matter of personal preference. Would you rather have full control over your investments or defer to a professional? Do you mind the tax uncertainty that comes with mutual funds?
Like with many financial matters, there is no right answer here. The best thing you can do is consider the pros and cons of each option, and make the decision that works best for you.