Stocks vs. funds: Which is right for you?

By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).
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NEW YORK (Money) -- Question: I'm planning to invest some money in the stock market, but I'm wondering whether I should buy mutual funds or individual stocks. Which do you think is better? And in the event I decide to go with stocks, which ones to you think are really good buys now? --Monique Thompson

Answer: The stocks vs. funds issue has always been a biggie for individual investors. But the question of whether you should go it alone or turn over your money to a mutual fund manager who'll invest it for you is even more critical today, if only because this uncertain economy and volatile market make the rewards for success and the cost of failure that much higher.

Clearly, the answer will vary from person to person, depending on such factors as how much money you have to invest, how well versed you are in the ways of the financial markets and how much time and effort you want to put into your finances.

It's also clear that each approach has advantages and drawbacks. With mutual funds, you get convenience, a diversified portfolio and the security of knowing that you have an experienced stock picker working full time on your behalf.

On the other hand, you have less control over your investments - not just which ones you choose, but when you recognize gains. That can be an issue when it comes to taxes. If the fund manager sells enough shares at a profit so that the fund has realized capital gains in a given year, you'll have to pay tax on a share of those gains even if you haven't sold shares of the fund (assuming you hold the fund in a taxable account).

If you decide to buy stocks on your own, you definitely have more control over what you own and when you sell. But you've also got to be willing to devote more time and attention to your investments.

So as I see it, the decision to go with stocks or funds comes down to a realistic assessment of how much you want to make your own investing decisions and your ability to handle that responsibility. Here are three questions you might ask yourself to help you with that assessment.

Am I willing (and able) to analyze companies' prospects? You don't have to be a rocket scientist to identify promising stocks. But you should be able to evaluate a company's finances. What sort of earnings growth is it likely to achieve? What's the value of its assets? Is it vulnerable because of a heavy debt load or a weakness in its product lineup?

But even that's not enough. You've also got to be able to assess whether it's selling at an attractive price. If a company has solid earnings and an impeccable balance sheet but is so popular that it's trading at a bloated share price, buying it may be an invitation to subpar returns.

There are many ways you can develop stock-picking skills. CNNMoney's Money 101section has easy-to-read lessons on everything from assessing stocks to putting together a portfolio. The American Association of Individual Investors also offers lots of information about stock investing [www.aaii.com/basics/] that's geared toward beginners, as does the Learn [www.weseed.com/learn/learn.html] section of relatively new site called WeSeed.

But until you at least familiarize yourself with the basics of stock investing, stick with funds (or at least keep all but a tiny portion of your money in funds).

Am I ready to devote the time and effort to monitor my holdings? As we know from recent experience, the investing world can change dramatically. I certainly don't want to suggest you need to be buying or selling stocks every time the market or the economy reverses course or the fortunes change for a company whose stock you own. But there may be times when you should react.

If a company's potential has dimmed, you may want to sell some or all of your shares and plow the proceeds into a firm that has a rosier future. Conversely, if one of your stocks has racked up such huge gains that it now represents an outsize percentage of your portfolio, you may consider selling some shares to avoid having too much riding on one stock.

There may also be times when you can turn the tax system to your advantage, say, by selling shares that are trading for less than you paid for them and then using the loss to trim your tax bill.

Keeping an eye on your portfolio and making occasional adjustments isn't a 24/7 job. But you should be prepared to spend at least a few hours a week tending to your holdings. If you're not disposed to put in that amount of time - and possibly more during periods of upheaval - then you're better off in funds, which generally require less attention.

Do I have enough money to make it worthwhile to choose stocks on my own? Here, mutual funds offer a clear advantage for most investors. By using a tool such as Morningstar's Fund Screener, you can easily find funds that allow you in for a minimum initial investment of as little as $500, even less in some cases. Many of the funds on our Money 70 list of recommended funds also require a minimum of $1,000 or less. And once you're in, you can typically add to your account in increments of $50 to $250.

If you want a reasonably diversified portfolio of stocks, on the other hand, you're talking about a much larger investment. You don't have to buy in round lots of 100 shares as was the case back in the day. But at the same tie you don't want brokerage commissions to eat up your returns. So even if you figure on paying a modest $10-per-transaction brokerage fee, you'd probably want to invest a minimum of $1,000 per stock in order to prevent your costs from exceeding 1% of the amount you invest. (Remember, you'll also have to pay a fee when you sell.) Assuming you'll need at least 20 stocks to create a balanced portfolio, you're talking about investing in the neighborhood of $20,000 to $25,000, if not more.

You can always invest smaller amounts, either initially or when adding shares. But the less you invest, the higher the percentage of your return that gets eaten up by brokerage fees.

One final tip: If you're relying on personal finance columnists or cable TV pundits for stock picks, then my feeling is that you probably shouldn't be in stocks at all.

The point to buying individual shares is that you think you bring something to the table that adds value and can boost your return - in-depth research, expertise at valuing securities, a sense of discipline that prevents you from buying or selling on emotion.

But if all you're going to do is buy on someone else's say so - in other words, substitute their judgment for yours - you'll save yourself a lot of time, energy and money by acknowledging that upfront and sticking to funds.