Index Funds, Mutual Funds, and Stocks: Which One Is the Best?

U.S. stock markets have created a lot of wealth for investors over the last three years. While billionaires have added to their wealth amid the soaring stock markets, retail investors have also reaped the benefits. When investing in markets, you can buy individual stocks or choose a polled investment vehicle like mutual funds or ETFs. Index funds, which are a subset of the mutual fund industry, are also a popular option.

All of these investment options have their unique characteristics. How do index funds, mutual funds, and stocks differ and which one should you choose for your portfolio?

Over the last few years, investing in stocks has looked easy. There have been multiple instances where young traders have outperformed even the best of fund managers by betting on a single stock—YOLO as they would call in the WallStreetBets lingo.

However, investing isn't that easy. Just look at the recent crash in meme stocks. Investing in individual stocks is risky and requires analytical skills, temperament, and time. If you lack even one of these, you might be better off in a pooled investment vehicle.

Pooled investment vehicles like mutual funds are popular among investors. Mutual funds can either be active or passive. In an active mutual fund, the fund manager is actively involved in the investment process and makes the buy and sell decisions. In a passive fund, the mutual fund buys all of the stocks in the index.

The most popular index funds are those that track the S&P 500 Index—the world’s largest and most benchmarked index. In an index fund, the returns are similar to that of the underlying fund after accounting for the expenses. Usually, index funds have a much lower expense structure compared to an active mutual fund.

Index funds and mutual funds help diversify the portfolio compared to individual stocks. While investing in individual stocks has its charm and there's a probability of a “home run” if you pick a multibagger, the flip side is that owning a dud can also spoil the portfolio’s performance.

Berkshire Hathaway chairman and legendary value investor Warren Buffett said that most investors might be better off buying an S&P 500 fund, which he calls a “cross-section of America.” He doesn't have kind words for those promoting active funds and thinks that the costs are high. A lot of active funds haven't been able to outperform the benchmark index despite charging a high fee.

ETFs have gained popularity over the last decade. There are passive as well as active ETFs. Unlike a mutual fund, which can only be bought or sold from the fund house, an ETF trades on the stock exchange, just like a stock. The biggest advantage is that an ETF can be traded anytime during the market hours, unlike a mutual fund which can be bought or sold only at the end of the day.

Stocks, mutual funds, and index funds are all good investment options. If you have the time and skill, stocks would be the best option for you. Otherwise, you can choose from the many index funds. An S&P 500 fund should ideally be a core part of every investor’s portfolio. Also, if you find an active fund attractive based on the fund’s strategy and the manager’s track record (which may or may not be replicated), you can opt for an active mutual fund as well.