Why do people invest in mutual fund rather than directly buying shares?

Question

I have seen a lot of people investing in a mutual fund rather than buying the shares directly. Though buying shares gives higher return, people tend to invest in mutual funds more.

Answer 1

Buying the right shares gives higher return. Buying the wrong ones gives worse return, possibly negative. The usual recommendation, even if you have a pro advising you, is to diversify most of your investments to reduce the risk, even though that may reduce the possible gain.

A mutual fund is diversification-in-a-can. It requires little to no active maintenance. Yes, you pay a management fee, but you aren't paying per-transaction fees every time you adjust your holdings, and the management costs can be quite reasonable if you pick the right funds; minimal in the case of computer-managed (index) funds.

If you actively enjoy playing with stocks and bonds and are willing/able to accept your failures and less-than-great choices as part of the game, and if you can convince yourself that you will do better this way, go for it. For those of us who just want to deposit out money, watch it grow, and maybe rebalance once a year if that, index funds are a perfectly good choice. I spend at least 8 hours a day working for my money; the rest of the time, I want my money to work for me.

Risk and reward tend to be proportional to each other; when they aren't, market prices tend to move to correct that. You need to decide how much risk you're comfortable with, and how much time and effort and money you're willing to spend managing that risk.

Personally, I am perfectly happy with the better-than-market-rate-of-return I'm getting, and I don't have any conviction that I could do better if I was more involved. Your milage will vary.

If folks didn't disagree, there wouldn't be a market.

Answer 2

There are several reasons.

One, mutual funds provide instant diversification. To build a diverse portfolio "manually" (by buying individual shares) requires a lot of time and effort. If your portfolio is not diverse, then it is wrong to say "buying shares gives higher return"; in many cases diversification will increase your returns.

Two, mutual funds reduce transactions costs. If you buy individual shares, you pay transactions costs every time you buy or sell. If you buy and sell the shares of many companies, you must perform many transactions and thus incur heavy fees. With mutual funds, a single transaction gets you access to many companies. In addition, it is often possible to buy mutual funds without paying transactions costs at all (although you will still pay fund expenses).

Three (sort of a combination of the previous two) it is just easier. Many people can easily buy mutual funds with no cost and little effort through their bank. It is also simple to set up auto-investment plans so that you automatically save money over time. All of these things are much more complicated if you try to buy many individual shares.

Four, if you buy the right kinds of funds (low-cost index funds), it is probably more lucrative than buying individual shares. The odds that, through carefully selected stock-buying, you will earn more than the market average are small. Even professional stock-pickers consistently underperform broad market indexes.

In short, it is not true that "buying shares gives higher return", and even if it were, the convenience and diversification of mutual funds would still be good reasons to use them.

Answer 3

How on earth can you possibly know what is going on in individual company X? The sole exception is if it is your own company.

The stock markets of the world are in fact a nest of sharks. The big sharks essentially make money out of the little sharks. Some little sharks manage not to be eaten, and grow bigger. Good luck with that.

"Insider trading" is, when found out, a crime these days. But "insider knowledge", "insider hints", "knowledge of market sentiment" and indeed just rumours about a given company are the kinds of things you won't particularly get to hear of in the fog of disinformation, and don't particularly want to waste your time with for a very uncertain loss or gain at the end of the year.

The thing I find annoying about mutual funds is that they can be very stupid, and I speculate that it may be the consequence of the marketing on the one hand, and the commission structure on the other. I started cashing in my funds in late 2007, following the collapse of Northern Rock here in the UK. The "2008" crisis was in fact the slowest economic car crash in history.

But very very few mutual funds saw, or seemed to see, the way the wind was blowing, and switch massively to cash. If the punters had the courage to hang on, of course, mostly stocks bounced back in 2009 and 2010. Moral: remember you can cash your stuff in any time you want.