Do you like things to be simple? Investing doesn’t have to be confusing! Let’s take 5 minutes and explore some of the primary investments that make up a portfolio and key differences between them.
Let’s start with stocks. Many people begin their investment journey by purchasing individual stocks of companies like Amazon or Apple and by using apps or websites such as Robinhood or E*TRADE. However, very few people understand what a stock is when they first start out. A stock represents a share in the ownership of a company including a claim on the company’s earnings and assets. When you buy that Apple or Home Depot or Amazon stock you become a partial owner in that company! This means that how your investment performs is directly associated with how the business is doing. Typically, over time, as the company’s earnings and assets increase, so will the value of your stock. The opposite can also be true if the earnings decline. One advantage of investing in individual stocks over other investment types includes that stocks sell in real time as they are traded on the New York Stock Exchange (NYSE) and the National Association of Security Dealers (NASDAQ). Another advantage is that stocks can help you achieve high returns compared to a diversified mutual fund or ETF. This advantage comes with taking more risk though. Remember your parents’ advice about not putting all your eggs in one basket? Your money is more concentrated if you own just a few stocks compared to several dozen stocks that a mutual fund may own. Stocks experience more volatility (highs and lows) than any other type of investment we will discuss today. Investing only in stocks is risky and many investors can have a hard time handling the emotions that come with the fluctuation of the stock on a daily or monthly basis.
Next, let’s discuss bonds. Simply put, a bond represents a loan from the buyer (you) to the issuer(company). This is different from buying a stock because you are not becoming a partial owner in the company, you are simply loaning money to a company or government entity that is issuing the bond. When you loan money to the entity, they agree to pay you back the face value of your loan on a specific date. What is the best part? You will be paid interest along the way (typically twice a year). Bonds that are likely to be paid on time (AKA high quality or investment grade bonds) typically offer lower interest rates. Like many things in life, the higher risk you take the higher potential return or reward you may be able to expect. Not having ownership in the company can reduce your risk of losing money when the company doesn’t perform well, but also limits your investment growth for the same reason. Bonds in general are looked at as a more conservative investment and can be good for setting up an income stream and offsetting some of the volatility that stocks may produce within a portfolio. There are many types of bonds that we could explore, but that is beyond the scope of this conversation.
You may be asking yourself, “Who wants to do all that stock research anyways?” One of the most common investments used in 401ks and investment accounts are mutual funds. Mutual funds are created and managed by financial institutions. They let you pool your money with other investors to ‘mutually’ buy stocks, bonds, and other investments. The big advantage of mutual funds is that they are run by professional money managers who do the research and make all the investment decisions for the fund they manage. Additionally, they provide diversified exposure. Instead of researching and buying 25 different stocks on your own, you can purchase a mutual fund that focuses on the area and types of companies you are interested in. This diversification typically allows for less volatility than a singular stock. Because of these advantages, mutual funds can be convenient, less risky than single stocks, and save you time on research. The primary trading difference between a stock and mutual fund is that funds only trade and are valued once per day, after market close. For long term focused investors, this is probably not anything to be concerned about. If you were a day trader, that is a different story.
The last form of investment we will discuss is exchange-traded funds, commonly known as ETFs. ETFs work very similar to mutual funds in that they pool together investor money to purchase securities and that they generally provide broad exposure to a specific asset class, region, or niche…just like a mutual fund. The key difference between ETFs and mutual funds is that while mutual funds can only trade and are valued once per day, at the end of the day, ETFs trade the same way as an individual stock. Meaning that ETFs can trade and are valued in real time, during market hours, at the price listed at that time. ETFs often have lower operating expenses compared to their mutual fund counterpart. This advantage can often lead to higher average returns compared to a mutual fund that held the same exact companies. There are also some tax advantages to holding ETFs inside certain types of non-qualified accounts. We can dive into that in another blog.
With the fundamentals now in your pocket, you should have a basic understanding of what stocks, bonds, mutual funds, and ETFs are.