Before we can begin investing, we need to understand the differences between a Stock, Exchange-Traded Fund (“ETF”) and a Mutual Fund. So here are the basics:
Stock. A stock is a type of security in which you own a small portion of a company’s assets and future earnings. These are also called shares or equity.
ETF. A diverse basket of securities which can be purchased through an online brokerage firm. ETF’s are offered on almost all asset classes, ranging from stocks and bonds to currencies and commodities. ETF’s are managed by a portfolio manager whose objective is to match the ETF’s performance to a benchmark or index. This is called passive investing or passive management.
Mutual Fund. Like an ETF a mutual fund is a diverse basket of securities. The main difference is a mutual fund is actively managed by portfolio managers who seek to beat their benchmark or index by using innovative investment strategies. This is called active investing or active management.
Napkin Note: Two of the most popular benchmarks in the equity market are the Dow Jones Industrial Average & the S&P 500. Benchmarks for the bond market are the Barclays Capital U.S. Aggregate Bond Index, the Barclays Capital U.S. Corporate High Yield Bond Index, and the Barclays Capital U.S. Treasury Bond Index. Mutual Funds use a Lipper index, which is the largest 30 mutual funds in a specific category.
Into the Details
Stock. If you are seeking to build a stock portfolio, then you will need to purchase individual companies. Creating your own stock portfolio requires intense research as you will want to study the company's financials, analyst research reports, quarterly (10-Q) and annual (10-K) statements, management of the company and the overall industry. I have attached the links to the 10-Q and 10-K for Apple, which you can access by clicking on the blue links above. This will give you a better idea of just how much material you will need to review before purchasing a stock. When building a stock portfolio, it is essential to keep diversification in mind. Diversification is a risk management tool where you construct a stock portfolio of different companies, industries, sectors, and regions, all aimed at reducing your exposure to one particular area. Typically a more diverse portfolio is one that is less volatile and will pose a lower risk than any individual security in your portfolio. Check out my example below.
Non-Diverse Stock Portfolio:
10 Shares of Apple
10 Shares of Microsoft
10 Shares of Google
10 Shares of Amazon
10 Shares of IBM
Diverse Stock Portfolio:
10 Shares of Apple
10 Shares of JP Morgan
10 Shares of Ford Motor Company
10 Shares of Starbucks Coffee
10 Shares of Exxon Mobil
The “Non-Diverse Stock Portfolio” invests in technology companies, so should technology companies underperform the overall stock market, your portfolio will lose more value than the “Diverse Stock Portfolio” which only has 20% exposure to the technology sector. Of course, the opposite is also true where if technology stocks outperform the overall market you will have a higher return on your investment. You will need to determine how much exposure to a specific industry, sectors, and region you want your portfolio to face.
ETF’s. ETF’s come with built-in diversification, which can help reduce risk and your overall losses, should you face any. ETF’s follow a passive investment strategy which aims to track a specific sector or index. When you purchase an ETF, you will pay an annual fee called the expense ratio. The expense ratio, covers administration, management, and advertising fees. These fees are different than the broker's commission. For example, if you want to purchase an ETF through Fidelity, you will have to pay the commission fee of $4.95 to Fidelity plus the annual expense ratio to the firm who manages the ETF. But the good news is Fidelity and other brokerage firm’s offer hundreds of ETF’s which are commission free. Fidelity also recently introduced two ETF’s called the “Zero Total Market Index Fund” and the “Zero International Index Fund,” which charges you 0.00%, while providing you exposure to the global stock market. Fidelity is the first to offer this, and I highly recommend you consider these two ETF’s as part of your investment portfolio.
It is critical to know the expense ratio before purchasing an ETF, as it can mean the difference between hundreds of thousands of dollars in your account over a lifetime. Nerd Wallet found that for a 25-year-old who has $25,000 in a retirement account, adds $10,000 to the account every year, earns a 7% average annual return and plans to retire at age 65, would cost the individual $590,000 in fees, if the expense ratio is 1.00%. By investing in ETFs with fees under 0.10%, the investor would save nearly $215,000 which works out to almost $533,000 through the magic of compounding over 40 years. This is significant money and the difference between retiring at 65 and having to wait several more years before retiring. If this investor owned either one of the Fidelity ETF’s, then, in theory, he or she would have $590,000 more towards retirement.
Check out the list of free ETFs you can invest in, by clicking the links below:
Mutual Funds. Traditionally mutual funds have been the preferred investment choice for millions of Americans when it comes to retirement planning. While the fact still holds true, many have begun switching to ETF’s and other passively managed accounts. The goal of a mutual fund is to beat an underlying index or benchmark, which is almost impossible to achieve year after year and is one of the reasons, many investors including myself, now favor ETF’s. Mutual funds are very similar to ETF's in that they both invest in a basket of diverse securities. Below I have highlighted the main differences between them.
1) Investment Minimums: Generally they’re no minimums to purchase an ETF, where a mutual fund may require at least $1,000 per investment.
2) Recurring Investments: You cannot make automatic investments in ETF’s, where you can set up automatic investments and withdrawals in mutual funds.
3) Fee Structure: As discussed above the fees are different and if the mutual fund is not outperforming the market than high fees may not be justified.
4) Active versus Passive Management: Where both are managed by professional portfolio managers, mutual funds pay large sums of money to portfolio managers to attempt to outperform the market. This is called active management, where ETF managers make sure the ETF contains similar characteristics and risk levels to its index or benchmark.
Ultimately you will need to determine how to construct your investment portfolio. The majority of my portfolio is invested in low-fee ETF’s, because I believe I am no smarter than the highly paid investment professionals, who by the way, still get it wrong sometimes. If you consistently save towards retirement or just a simple investment account and can earn between 6% - 8% per year on average, I think you will be pleased in forty years from now. Please leave comments and questions below.