For most people who are new to the world of personal finance, the nuances of the difference between mutual funds and life insurance policies are confusing. Here is a quick summary of the two products that can help you to at least get a high level understanding of the difference between the two products.
A mutual fund is a capital market investment product that gives you a return based on the amount of risk that you are taking. Your investment is exposed to the risk of the capital markets, and there are no guarantees that your invested amount will be totally safe or preserved. As of August 1, 2009, investing in mutual funds does not require you to pay any fees to the fund management company at the time of investment.
Life insurance on the other hand is not an investment product, but rather a protection product that will compensate your family or survivors in case something happens to you. You can be assured that the insurance company is contractually bound to meet its obligation to your beneficiaries in case something happens to you. To get this protection and security, you pay a premium. Generally speaking, basic protection does not cost that much. Sometimes you might choose a policy where you pay a higher premium amount in order to get an assured or estimated return on this money at the time the policy matures, in addition to all the protection benefits associated with the policy.
There are yet other types of life insurance policies, called Unit Linked Plans that have a mutual fund like investment product attached to them. So along with paying for risk cover against your life, you get an investment product where you can choose the type of fund to invest in. Please understand that such type of hybrids can be recreated by you by simply combining a pure life insurance product along with a mutual fund. And, you will pay lesser in fees if you do this on your own, because these hybrids have much higher fees.
Both mutual funds and insurance products should be seen as long-term in nature, i.e., products that you will hold for an extended period of time rather than get in and out of every other month. They can also be seen as ways to create a pool of capital or asset for future use.
In mutual funds you can use your capital to either generate current income, through dividends, or capital appreciation for use in your later years in life like in retirement. With a simple life insurance policy, you are not generating any current income, but your family is contractually guaranteed some monetary compensation in case something happens to you. Or, some types of endowment insurance policies offer you a minimum amount of capital at the expiry of the policy, based on the amount of annual premium that you would have paid during the life of the policy.
If you are looking to invest and already have adequate life insurance coverage, then you are probably better off investing through mutual funds. You can have the flexibility of choosing from a variety of funds and taking risks according to your risk appetite, and retain the ability to changes funds conveniently. You can stop adding to your investment in the fund if you so choose.
However, if you don't have life insurance coverage and are also thinking of getting some capital appreciation, then a hybrid (life insurance with an investment product attached to it) or an endowment policy might be suitable for you. Keep in mind that unlike a mutual fund where you can choose to stop adding additional capital to your portfolio, in life insurance you have lesser flexibility and you might be forced to pay your premium at regular intervals across the duration of the policy. You should not buy insurance and then stop paying the premium as your "sunk cost" (money you have already paid) might not be recoverable if the policy were to lapse.
Ultimately, you need to decide what your needs are and whether the product you are looking at meets your needs or not. Remember, as a simple rule consider mutual funds for investments, and life insurance to protect your financial dependents in case something were to happen to you.
