Learning to invest? We cover some of the basics of stocks, mutual funds and ETFs.
If I were to ask 10 everyday people to tell me what they think of stocks, ETFs, and mutual funds, I bet the results would look something like this:
- All of them would have some preconceived notion about stocks.
- Most of them would have heard of mutual funds.
- And maybe 1 or 2 would know about ETFs.
Interestingly, the ETF, although widely unknown, is one of the fastest growing investment products in the financial realm. But let’s take a look at all three of these financial vehicles and see how they stack up.
The Scoop On Stocks
First, although in a strictly legal sense, a person who owns a share of stock doesn’t technically own a small piece of the company, it’s quite alright to think of it that way. Other than cash, a stock is the purest way to invest because it is a direct investment in one company. This can be both good and bad. It’s good because when good fortune follows that company, the investor will reap the rewards of that good fortune. The downside is that an individual stock exposes you to financial risk and is vulnerable to the effects of negative events at several levels: a stock is sensitive not only to shifts in the market but also to shifts in the underlying industry and company it represents. In order to control risk and have a reasonable shot at making money, an investor must diversify. This is impossible with a single stock so it is not advisable to have all of your money in one basket, so to speak. For more on this subject, check out our stock investing tips and our advice on how to trade stocks.
The Matter With Mutual Funds
There are two ways to ensure that your investments are adequately diversified, other than buying a fistful of unrelated stocks: you can choose to own mutual funds or ETFs (exchange traded funds). Many of us happen to be very familiar with the mutual fund as a type of investment that’s made available to us through our retirement plans at work. If you have a company sponsored retirement account such as a 401K, you probably own shares of a mutual fund. There’s the kind that’s actively managed and then there are the uber popular index funds. In both cases, there are baskets or collections of investments that form the fund. Think of them in terms of a puzzle. There are many pieces that come together to make the picture. There is a manager of the fund who is buying and selling mostly stocks and bonds for the fund in an attempt to make you money.
Image from Fidelity Investments
The sad truth is that these fund managers are largely unsuccessful about keeping pace with the market (forget about beating it!) because the fees that are charged to the customer (you and me) wipe out some of the gains made by these funds. In other words, fund managers must achieve extra gains just to make sure they’re able to cover the fees and charges that go with operating and managing their funds. But here’s the bright side: investing in mutual funds is a great investment strategy for those investors who do not have time to follow their money closely. Stock mutual funds (particularly index funds) are a nice step above extremely safe high interest savings accounts and money market funds, and a great way to get your feet wet with equities.
Exchange Traded Funds or ETFs
The ETF is similar to the mutual fund in that it is a basket of investments that’s often quite specialized. Just like mutual funds, ETFs have a particular investment focus. There are ETFs that are only made up of technology stocks, or energy stocks. There are those that follow the movement of the Chinese economy and those that track a basket of commodities like corn and wheat. While ETFs are traded on an exchange throughout the day just like a stock, a mutual fund only trades at the end of the day.
ETFs do have managers but they are not managed as actively as some mutual funds. Most of the underlying stocks stay the same over time which helps keep the fees on these funds much lower than what you’ll experience with many mutual funds.
Much like mutual funds, ETFs work well for the retail or part time investor because they have some diversification already built in, given that they represent a collection of stocks (or other assets). With an appropriate amount of research and patience, you may find that owning ETFs can be a successful investment strategy; these assets can certainly become a healthy part of your portfolio.
For a quick visual comparison of how stocks, mutual funds and ETFs compare, here’s a table I’m shamelessly borrowing from the ETF Database, a great resource for everything on ETFs:
So Where To Invest Your Money?
I and many others believe that you should think of your investments in two parts: your retirement money and your discretionary money. My opinion is that the best place for your retirement money should probably be in mutual funds. Your money should be in a mix of safe funds and relatively more aggressive funds depending on your age and how close to retirement you are. Although mutual funds may not soundly beat the market, they do tend to track it closely — particularly if they’re index funds — so over time, you can expect to accumulate a healthy retirement if you leave your accounts alone. I would certainly not take egregious risks with my retirement money.
As for the other portion of your assets — your discretionary money — you can place this in any investment you feel comfortable about, whether it be in stocks, ETFs, mutual funds (or in bonds, REITs and other asset classes) but I’d be careful to do sufficient research before taking on any risk. The important thing is to stay well-informed, diversified and realistic about what you can earn from your investments. Keep in mind that whatever you invest and put at risk shouldn’t affect your family adversely should losses occur due to a bad decision.
Take a look at all these types of investments and decide what is appropriate for you. If you don’t feel comfortable making that choice, talk to a trusted expert in your area. And learn as much as you can.
Contributing Author: Tim Parker from Elementary Finance
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