What’s The Difference Between a Stock, Bond and Mutual Fund ?

A stock is ownership in a company.  When you buy a stock, you buy a piece of the company.  So if the company does well, you do well.  Congruently, if the company tanks, your stock tanks.  Just like bonds, there are many types of stocks because there are many different types of companies out there.   Large company stocks (large cap), mid cap stock, small cap stock, international stock, emerging stock, tech stock, etc.   Historically, stocks have an annual average return of 10.8%.

However, remember that with more return comes more risk.  So when investing in stocks, keep in mind that you have to be able to handle the extra risk or volatility to reap the potential reward in the long run. 

Using the Rule of 72, if you have $5,000 in stocks that average 10% return overtime, it will take you 7.2 years to double your original investment to $10,000.  By the end of 36 years you will have potentially $160,000.  Compare that to the $10,000 you will have after 36 years if you leave your money in just cash investments.  Now you can start to see why taking on the extra risk can become worth it in the long run.

Bonds:

The best way to describe a bond is to think of it like a loan.  You loan your money to the government or a company, and in return they pay you interest for the term of that loan.  Typically bonds are considered conservative types of investments because you can choose the length and term of the bond and know exactly how much money you will get back at the end of the term or “maturity.” 

There are many types of bonds; government bonds, corporate bonds, short-term bonds, long-term bonds, municipal and inflation protected bonds, etc.  Generally bonds are less risky than stocks and the main way you lose money on a bond is if the company or government issuing the bond defaults on their obligations.  Historically, bonds have an annual average total return of 6.3%.1  Again, using the Rule of 72, and have $5,000 in bonds that average 6% return overtime, it will take you 12 years to double your original investment to $10,000.  Better than cash but still not that great.

Bonds are subject to market risk and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Mutual Fund:

Mutual funds represent another way to invest in stocks, bond, or cash alternatives.   You can think of a mutual fund like a basket of stocks or bonds.  Basically, your money is pooled, along with the money of other investors, into a fund, which then invests in certain securities according to a stated investment strategy. The fund is managed by a fund manager who reports to a board of directors.  By investing in the fund, you own a piece of the pie (total portfolio), which could include anywhere from a few dozen to hundreds of securities. This provides you with both a convenient way to obtain professional money management and instant diversification that would be more difficult and expensive to achieve on your own. Every mutual fund publishes a prospectus. Before investing in a mutual fund, get a copy and carefully review the information it contains, such as the fund’s investment objective, risks, fees, and expenses. Carefully consider those factors as well as others before investing.

When we say Equity, what comes to your mind – Stock or Equity Mutual Fund? While a single stock or a mutual fund both comes under the category of Equity and they are good option for long-term investment and needs periodic review. There are some differences between stock investing and mutual fund investing that is done by a common man. It’s a good idea to know where they differ and in which situation they differ, so that one can take better investing decisions. Let’s look at the main differences

Stocks and Mutual Funds Difference

Volatility

When you invest in a single stock or bunch of stocks (3-5 scrips), the change in it’s value is very high. On a given day it can be extremely volatile. It can give you 20% return and sometimes -10% loss also depending on the environment. This can be very exciting and at the same time very disheartening and gives you a feeling that you need to “act fast”.

Mutual fund on the other hand is not that much volatile by nature, as the diversification is very large and at a time 50-100 stocks are covered. Different kinds of stocks from different sectors and market capitalization are involved in mutual fund and the over all change in value is thus less volatile (other than extreme days).

Return Potential

This is very much in line with the above point but still let’s look at it separately. There are lot of success stories where someone got quick rich by investing in equities directly and it can happen, but those are rare happenings and require lot of work and analysis, patience and belief in what you have picked. If you want superb returns in short time and you believe you can research well, you can go for stock investing directly but then risk is also more.

Mutual funds are known to deliver good returns (not in line with stocks, but still very good). So you can expect handsome returns from mutual funds but not unbelievable like stocks return. This is mainly because the money is diversified across different stocks and chances of all of them becoming a super success in short time is impossible.

Monitoring Required

Stock investing is a personal affair and you are doing it on your own the decision of what to sell and what to buy is on you. Even in case of long-term investing, you might have to keep an eye every quarter or yearly unless you have really spent some good time in picking the good stock. You need to also keep an eye on news and sector specific developments.

Monitoring in mutual funds is relatively low because the job of monitoring is anyways done by the fund manager who is paid SALARY to filter through the fluctuations. He constantly adds and removes the stocks from the portfolio. This can be a positive point, but sometimes it can be a negative point also if there is too much of churning.

SIP Investment

Mutual funds are known for possibility of SIP (monthly investment). SIP in mutual fund works and is recommended as a great way for a salaried person to invest in equity markets for long-term basis without understanding the working of equity markets.

However SIP in stocks do not work. Yes, some companies provide you the facility of SIP in stocks, but it’s a terrible concept. There is no diversification and SIP in a particular stock does not make sense because the risk is with single stock. A stock can be in a bad phase for years and decades, whereas in a mutual fund the bad performing stock is weeded out.

Asset Class Restriction

Stocks investing is restricted to Stocks only. You can choose a large cap stock, mid cap stock or small cap stock, but finally it will be equity asset class. However, mutual funds can invest in mix of asset classes. There are equity funds, debt funds, gold funds, Mix of Equity and debt also. To top up, even balanced funds are there which can adjust the asset allocation on its own, so in a way mutual funds are more superior in terms of features compared to a single or bunch or stocks.

Mutual Funds are actually collection of stocks only but just because it’s a group of stocks the characteristics are not very similar to that of stocks. You should be clear about all the points of difference and only after that you should decide whether to invest in Stocks directly or take the Mutual Fund route.

The price of a mutual fund does not vary during the course of the trading day because it is set at the end of each trading day. You buy or sell a mutual fund at the end of the day after the price for that day has been set, based on the value of the individual investments in the Fund. So if the price of the Mutual Fund you want to buy is $45.00 per share and you place an order to buy $10,000 you will acquire 222.22 shares at the end of the day.

All mutual funds have expenses including commissions, redemption fees and operational expenses. Commissions or loads as they are sometimes called are either front-ended or back-ended, meaning you can a commission when you either buy or sell, respectively. There are also no-load or non-commission mutual funds and are much preferred. Redemption fees are to discourage excess turnover and occur only if the fund is sold prior to a specific period of time. Operational fees include managements’ expertise and miscellaneous fees such as for advertisement or distribution expenses. On average, Mutual Fund annual expenses can range from as little as 0.1% to as much as 3% or more per year. These expenses are not seen by the investor on the monthly statements and are somewhat hidden and can have an impact on your overall return.