Why Mutual Funds and ETFs are Considered Less Risky than Stocks?
Mutual funds and ETFs are recommended to investors who are just starting out as a less risky way of investing in the stock market than investing in individual stocks. Let's see the differences between mutual funds, ETFs, and stocks and why some of these investments may be safer than others.
What is Stock?
In simple terms, a stock is a piece of a company. You can think of a stock as a certificate that represents ownership of a portion of a company. The more of these certificates you have, the larger the share of a company you own. People who own stocks are called shareholders. Because shareholders "own" a portion of a company, they are entitled to a portion of that company's profits. The profits are paid to shareholders in form of dividends or reinvested into the company's growth, which increases the value of the stock.
Example: If a company issues 1,000 shares of stock and you buy ten shares, you would "own" one percent of the company shares and earnings. In practice, large corporations issue hundreds of millions or even billions of shares. When you buy ten shares of well-known stock, you own a tiny fraction of the business.
Why Do Companies Sell Their Stocks?
Companies issue and sell stocks to raise cash for running and expanding the business. For example, a company needs to expand by building new plants to meet the increasing demand for its products. Instead of taking a loan, the company can sell a portion of itself to raise enough money for expansion. A company also can buy back its own stocks to invest in itself.
What is a Mutual Fund?
Mutual funds pool money from many people and invest it in stocks, bonds, short-term money-market instruments, other securities or assets, or sometimes a combination of these investments. In other words, a mutual fund raises money by selling shares of itself to buy investments that become a part of the fund. Think of a mutual fund as a basket that contains a mix of investments.
The shareholders own portions of the basket rather than the individual investments. These "basket investments" can track specific sectors, such as stocks of the companies in energy sectors, or indexes, such as the S&P 500, or they can invest in a mix of hundreds or thousands of stocks. Instead of owning individual securities, each investor owns a piece of the whole fund of mixed assets for the price of one share.
What is an ETF?
ETFs (Exchange-traded funds) are very similar in many respects to mutual funds, but they have some differences. Similar to a mutual fund, an ETF is a collection of stocks, bonds, and other securities. ETFs can include mutual funds as well. ETF's shareholders own pieces of the fund of mixed assets instead of individual securities.
What is an Index Fund?
Sometimes a fund will have the word index in its name. An "index fund" is a type of fund that tracks a market index. A market index is a specific group of stocks, bonds, or other investments. For example, the S&P 500 is an index of 500 leading U.S. publicly traded companies. A fund that follows this index as closely as possible, or in other words, is comprised of stocks of these companies, is an index fund. Both mutual funds and exchange-traded funds can be index funds.
Actively Managed Funds
Besides index funds, mutual funds or ETFs can be actively managed funds. Actively managed funds are not based on indices. Money managers of active funds pick any investments that they think will do better in the hope of beating the market returns. Active funds cost more to run than index funds, and the fees of actively managed funds are significantly higher than the fees of index funds.
Mutual Funds vs. ETFs: What's the Difference?
Both mutual funds and ETFs are professionally managed collections or "baskets" of individual stocks or bonds. However, the main difference between them is how mutual funds and ETFs are traded.
Orders to either buy or sell mutual funds can be placed at any time but are executed at the end of the trading day at 4 p.m. Eastern Time. Every trader who buys or sells shares does so at the same price which is determined at the close of the stock market. Exchange-traded funds, as the name suggests, provide real-time pricing and the shares can be bought and sold whenever the market is open, just like stocks.
If you want to learn about other diferences between mutual funds and ETFs, see ETFs vs. Mutual Funds - What's the Difference?
Why Mutual Funds and ETFs are Considered Safer Investments?
Mutual funds and ETFs are typically considered safer long-term investments because of their broad diversification. Individual securities, such as stocks, can fluctuate in price drastically or even lose most of their value due to numerous factors ranging from political and market events to something completely unexpected, like pandemics and wars. It is not possible to foresee all of these factors and pick individual stocks that will perform well in every market condition. Exposure to a single stock, single industry, or single investment option is therefore very risky.
Mutual funds and ETFs are comprised of hundreds or thousands of stocks, bonds, or other securities, which offsets risks through diversification. In a diversified portfolio, securities that perform well will help offset the losses of the securities that struggle. Achieving and maintaining a properly diversified portfolio that is made up of many individual securities is an involved and expensive process. By investing in mutual funds and ETFs, investors get diversification by default. Diversification mitigates the risks to which individual investment options are exposed.
In summary, the main reasons why investors may choose to buy mutual funds and ETFs instead of individual stocks are diversification, convenience, and in most cases, lower costs.
Read more: Diversification: Important Concept in Investment Management
Some Mutual Funds and ETFs are Riskier than Others
We learned that mutual funds and ETFs are collections of different financial assets. Because the nature of these collections is different - different types of funds are exposed to different risks and therefore perform differently.
Example: Although energy ETFs, funds that invest in the companies focused on exploration and production of energy, are diversified across different corporations, they are not diversified within industries. If the energy sector suffers a broad selloff, these ETFs will be impacted much more than ETFs that track the performance of the total market index. Some funds are less diversified than others and for that reason can be riskier than others, although still safer than individual stocks.
Why Invest in Stocks if Mutual Funds and ETFs are Safer?
It all comes down to "high-risk, high-reward" investment strategies. High-risk investments, like some individual stocks, offer the prospect of returns that can potentially be higher than those from safer investments. These investments are considered high-risk because there is no guarantee they will deliver high or any returns in practice.
Example: An example of a high-risk, high-reward investment is the stock of a biopharmaceutical company that is working on developing a promising drug. If the company succeeds - the stock price may increase by several folds, resulting in a high reward. But if the research fails or the drug is not approved by governmental agencies - the stock price may go down below the initial price and stay there for a long time.
Bottom Line
Mutual funds and ETFs are a good choice for beginner investors and those who want to invest passively and avoid the risks and hustle associated with owning a portfolio of individual stocks. Although it is possible to find the big winners among individual stocks, many financial experts and experienced investors agree that most average investors will have strong odds of doing better in the long term with mutual funds and ETFs.
There is nothing wrong with mixing and matching various investment options in your portfolio, as long you understand the risks and have a thought-through strategy. In addition to mutual funds and ETFs, a diversified portfolio may include other investments, such as individual stocks, bonds, real estate, and other options that are appropriate to your situation.