Ask Doug

I Have $200 to Invest Each Month. Should I Invest in DRIPs or Mutual Funds?

Q. I am a college student on full scholarship and receive a monthly stipend each month of $200. I would like to buy stock, and was thinking about a DRIP or a mutual fund. But mutual funds scare me because of taxes. What do you think the most productive route would be?

A. As far as taxes go, when you invest in a DRIP stock, you pay taxes on dividends in the year in which they were received, and then on any capital gains at that point when you sell a stock. If you buy a stock and hold onto it for a long time, you may have a large gain, but you get to control the tax burden by deciding when to sell (if ever).

With mutual funds, you'll get distributions of income and gains each year from the fund, and you'll be liable for taxes on those distributions, as well as any capital gains when you sell the fund. You can minimize your tax liability by investing in a mutual fund with low turnover -- one that doesn't buy and sell stocks very frequently. Index funds are great for that purpose -- they buy and hold stocks, generating very little tax liability.

If you invest in an IRA or Roth IRA, of course, you can defer or eliminate the tax liabilities. You might consider investing part of your monthly stipend in a Roth IRA if you're eligible, and the rest in a taxable account at a mutual fund or in a DRIP.

Besides taxes, one advantage of mutual funds is that they provide instant diversification since the fund will own hundreds or thousands of securities; a diversified portfolio provides some measure of risk control since you're not at the mercy of watching in horror as a single stock plummets in price, taking your entire portfolio value along with it. If you invest directly in stocks, it will take some time to build up a diversified portfolio. Your personal tolerance for risk will dictate which approach is most appropriate.

An advantage of investing directly in stocks is that you will learn how best to analyze companies and find the best candidates for a long-term portfolio. DRIPs offer great opportunities for investing on a shoestring budget and learning how the stock market works in practice.