Stocks and Mutual Funds: What’s The Difference?
For many new investors, getting into the equities market means making a choice between two main investment types of investment instruments: mutual funds and individual stocks. Let’s take a look at some of their characteristics so that we can understand the differences between these two investment selections.
Mutual Funds and Exchange-traded Funds (ETFs): Mutual funds (sometimes referred to as “equity mutual funds”) allow investors to purchase stocks as a collective group. ETFs and index funds often have a specialized focus and might track assets like gold and oil, or the S&P 500. One popular example is the SPDR S&P 500 Trust ETF (NYSE: SPY), which replicates the performance of its benchmark and allows investors to gain exposure to each of the component companies in the index. By investing in a fund like SPY, it is actually possible to assume ownership of a small piece of every company in the S&P 500. Investors can also buy several funds in conjunction with one another as a way of building a more diversified stock portfolio.
Individual Stocks: When investors are looking to buy into a specific company, it’s possible to buy shares of a single stock. Common names include stocks like AT&T, (NYSE: T) or Apple, Inc (NASDAQ: AAPL) and stock experts will generally recommend that investors build a diversified portfolio of companies across industry sectors. Buying individual stocks can increase the potential for substantial returns (when compared to mutual fund investments). However, the risk for potential downside is equally apparent and individual-stock investors must have a clear plan of approach before gaining exposure to individual companies.
Stock Investing vs. Stock Trading
When making the decision to buy into stocks or mutual funds, it’s important to understand the differences between stock investing and stock trading. For stock investors, the main goal is to build wealth gradually and to establish positions over an extended period of time. This generally requires an investor to hold positions in a stock portfolio for years or decades, although this will depend greatly on the strength or weakness of the market.
When investors hold positions over longer time intervals, it is possible to collect the benefits of dividend payments, stock splits, and the historical bull trend that has characterized equities markets for hundreds of years. Over shorter time frames, markets will inevitably show fluctuations and minor downtrends but it is possible for investors to “ride out” these negative periods and wait for the rebound. Stock investors tend to be more heavily focused on market fundamentals (i.e interest rates, GDP growth, industry forecasts, retail sales, price/earnings ratios and the level of debt held by individual companies).
Stock trading deals with market transactions (buying and sellling) that are much more frequent. For stock traders, the main goal is to generate profits that outperform returns captured through traditional buy-and-hold investments. Where a stock investor might find annual returns of 10-15% to be sufficient, stock traders might aim to generate returns of 10% every month.
Stock traders make their money buying equities at lower prices and selling at higher prices —all completed within relatively short periods of time (i.e. minutes, hours, or just a few days). Stock traders can also profit from short-selling activities, where the goal is to sell equities at a higher price and buy back the same shares later (at a lower price). In contrast, buy-and-hold investors wait out less profitable positions, traders seek to make profits within a specified period of time and often use a protective stop-loss order to automatically close out losing positions at a predetermined price level.
Stock Trading Strategy Types
Stock trading styles will generally depend on the time frames that are used to construct positions. In this regard, stock traders will usually fall into four categories:
- Position StockTrader: Stock trades are held for a period of a few months to several years.
- Stock Swing Trader: Stock trades are held for a period of a few days to several weeks.
- Stock Day Trader: Stock trades are held during a single trading session (with no trading positions held overnight).
- Scalping Stock Trader: Stock trades are held for a very short-term period of seconds to minutes (with no trading positions held overnight).
Most of these stock trading strategy types (particularly swing traders, day traders, and scalpers) tend to rely on technical analysis techniques as a way of constructing their positions. Essentially, technical analysis is the practice of using historical price charts as a way to predict the direction that stock prices will travel in the future.
Stock traders will often employ the tools of technical analysis in order to identify trading setups with a high probability of success. These common technical analysis tools include:
- Moving Averages
- Stochastic Oscillators
- Elliott Wave Theory
- Bollinger Bands
- Trading Volume
- Parabolic SAR
- Trend Analysis
Each of these technical analysis techniques give traders different information about the most price trajectory a stock is likely to experience in the future. In many cases, expert technical analysis traders will combine multiple studies in order to get a more objective viewpoint about where stock trends are headed next.
Trading Stock Options
Stock options refer to trading contracts which give the holder the right to buy or sell a stock at a set price within an established period of time (the length of the contract). For stock traders, options can be powerful because of the ways they enhance equities portfolio strategies. Stock options can offer traders additional income, added position protection, and provide leverage for a broader portfolio strategy. Depending on the underlying conditions of the market, there may be several options strategies that can be used at any given time.
Use of Robo-Advisors
For those looking for a more automated type of strategy, robo-advisors have become quite popular following the financial crisis of 2008. These software systems help investors construct an approach to stock portfolio building using various inputs of personal data. Services provided by these tools include portfolio rebalancing and harvesting tax losses. Recent surveys in the United States show that 58% of investors are likely to begin using some sort of robo-advisor by 2025.
Reducing Risks Through Diversification
Diversification is a strategy stock traders use to invest in a broad range of assets. This helps reduce risks that might be associated with the investment performance of any single asset in a stock portfolio. In simple terms, diversification strategies help investors avoid putting “all eggs in one basket.” One simple way to achieve diversification is through the use of mutual funds or exchange-traded funds (discussed above), however, these instruments are generally not used in short-term trading strategies because of their higher fees.
For new stock traders, it’s possible to begin investing with small account sizes. However, in these cases, it’s important to take a conservative approach to the market and to avoid chasing stocks that have already made a significant price move. When using a balanced approach to stock investing, it’s possible to limit losses while maximizing the potential for gains.
Trader Summary: Stock Trading
- The stock market is a collection of exchanges where investors can buy or sell shares of publicly-traded companies and profit from their relative price differences.
- Many new stock investors begin after making a choice between two main investment types of investment instruments: mutual funds and individual stocks.
- The second major stock market decision is choosing between stock investing and stock trading.
- For stock investors, the main goal is to build wealth gradually and to establish positions over an extended period of time.
- Stock trading deals with market transactions (buying and sellling) that are much more frequent. For stock traders, the main goal is to generate profits that outperform returns captured through traditional buy-and-hold investments.
- Stock trading styles often depend on the time frames that are used to construct positions. Stock traders will generally fall into four main categories: position traders, swing traders, day traders, and scalpers.
- An option contract gives its buyer the right to buy or sell a stock at a set price by a certain date in the future.
- Robo-advisors are automated software systems help investors construct an approach to stock portfolio building using various inputs of personal data.
- Diversification is a strategy stock traders use to invest in a broad range of assets, which helps reduce risks associated with the individual assets held in a stock portfolio.
- Assuming a conservative approach to the stock market is generally advisable for newer traders that are speculating with smaller account sizes.