Let's Break It Down: Stock's, ETF's, and Mutual Funds

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:

Fidelity

E-Trade

TD Ameritrade

Charles Schwab

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.

Show Me How To Invest

Investing can be complicated, but I believe it can be simplified so the everyday person can use investing as a tool to build wealth. The goal of this post is to simplify the investing process by guiding you through 5 steps that describe my personal investment making decision process. This process has produced some fantastic results for me over the past 10 years, and I hope you will consider some or all of them before investing.

Step 1: Big Picture – Current State of the Global Economy and Geopolitics

Step 2: General – Sector and Industry Focus

Step 3: Specific Company

Step 4: Invest

Step 5: Re-evaluate Your Investment Every Quarter

Step 1: Big Picture – Current State of the Global Economy and Geopolitics. Identifying if the world or country is in a state of growth is relatively simple on the surface. Our first step is to look at the gross domestic product (“GDP”) of the world or a specific country. This is one of the most commonly used economic indicators of growth. GDP is the total value of goods and services produced by a country in one year or a specific time period. But to determine if a country is growing, we need to be able to pinpoint where in the economic cycle the country is currently. So what is an economic cycle?

According to Investopedia, “the economic cycle is the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (“GDP”), interest rates, levels of employment and consumer spending help to determine the current stage of the economic cycle.” An economic cycle is broken down into four distinct stages; expansion, peak, contraction, and trough. “During the expansion phase, the economy experiences relatively rapid growth, interest rates tend to be low, production increases and inflationary pressures build. The peak of a cycle is reached when growth hits its maximum output. Peak growth typically creates some imbalances in the economy that need to be corrected. This correction occurs through a period of contraction when growth slows, employment falls, and prices stagnate. The trough of the cycle is reached when the economy hits a low point in growth from which recovery can begin.” So where and how do we invest based on an economic cycle? Well, it really depends on the type of investor you choose to become. You can trade based on short-term (1-30 days), medium-term (2-12 months), or on a long-term (1-30 years) basis. Throughout Brett’s Napkin, I generally advocate for a long-term investment strategy. Research has proven if you stay invested throughout many economic cycles, instead of choosing to buy and sell based on current economic conditions, you will have a higher return on your investment. Now they're exceptions to this, but all of us have a life outside of investing and are only using investing as a tool to generate growth. We want to stay humble, smart and try not to outsmart the market, because in the end, no one is smarter than the market itself.

Some of the critical indicators described above are GDP, interest rates, unemployment rate, wage growth, and consumer confidence. These statistics for the United States can be found on the Bureau of Labor Statistics (https://www.bls.gov/home.htm), and the Federal Reserve Bank of St. Louis (https://fred.stlouisfed.org/). These two sites are an excellent starting point to learn more about the current health of the U.S. economy by analyzing statistics. As you are conducting your research look at the last several years of each indicator and try to create the current economic cycle. This will enable you to pinpoint where in the cycle an economy currently is.

Thanks to technological advancements and an opening of the global economy, you can invest in virtually any market across the globe. So how do we learn about which countries are growing and which are not? Take a look at the Wall Street Journal and the Economist. Both are excellent sources of useful information so you can stay up to date on current events and learn about new investment opportunities. Another great source of information is Citi GPS. Citi GPS produces excellent content on the global economy’s most demanding challenges, identifies future themes and trends, and help’s you invest in a fast-changing and interconnected world. And best of all it is free to the public.

Once you determine which country or region of the world you want to invest in, you need to review the current political environment. We are now in a world where a single “tweet” can shave 10% or more off a company’s stock price in a single trading session. Generally speaking, investing in a county with a democratic system of government and one that advocates for open markets, and has strong and stable democratic institutions, like the ones of the United States, United Kingdom, France, Japan, and Australia, to name a few, are called advanced economies (“AE”). Where those of China, India, Brazil, and Nigeria are called Developing Economics (“DE”). Napkin Note: AE's are ones who have stable political systems, advanced manufacturing capabilities and a high standard of living. Generally speaking, these economies are less risky to invest in and thus will have a lower growth rate on your investment. Whereas DE's are in the growth stages of development and there is greater potential for rapid growth and thus higher investment returns. Portfolios containing both AE and DE investments are all part of creating a well-balanced, diversified portfolio.

Step 2: General – Sector and Industry Focus. At this point, you have determined the countries and or regions you want to invest in. You now need to narrow down your search down to the sector and the industry you want to invest in. The main difference between a sector and industry is a sector refers to a large segment of an economy, while the industry is specific to a group of companies. After reading the WSJ, Economist, and Citi GPS for a few weeks, you will begin to see opportunities in specific sectors and industries. Below I have identified 11 sectors and 68 industries, which apply to the U.S. Economy. Fidelity does a great job explaining each one of these sectors and industries and then allows you to use a Stock/ETF/Mutual Fund Screener to find specific investments within each sector and industry. I encourage to read more about sectors and industries through your brokerages’ education center. By using comparison tools, you will learn which areas are growing and why.

Sectors-and-Industries.jpg

Step 3: Specific Company. Over the last ten plus years, if I can share one tip about investing it would be to leave your ego and emotions at the door. If you choose not to, then please don’t invest and head to Las Vegas, because investing is all about calculated risk-taking, following a specific set of rules, and not bringing your emotions into the room. Thus creating rules and sticking to them is the best strategy for success. William O’Neil is a brilliant investor and the founder of Investor’s Business Daily (“IBD”). IBD is a weekly paper, providing news and analysis on investment opportunities. They specifically focus on "stock-picking," and is a great tool to find new investments for your portfolio. In addition, William O’Neil created 20 investment rules for success, which I highly recommend you follow. I have listed these rules below. Some of these rules make references to the IDB paper, which you would need to purchase in order to follow the individual rule. For now, you can substitute these rules with one of mine which I have listed below the IDB Rules.

  1. Consider buying stocks with each of the last three years’ earnings up 25%+, return on equity of 17%+ and recent earnings and sales accelerating.

  2. Recent quarterly earnings and sales should be up 25%, preferably 40% or more.

  3. Avoid lower-quality stocks. Buy stocks selling for $15 to $100 or higher.

  4. Get and use charts to spot sound chart bases and exact buy points. Confine your buys to proper points as stocks emerge on big volume increases.

  5. Cut every loss when it’s 8% below your cost. Make no exceptions so you’ll avoid any possible huge, damaging losses. Never average down in price.

  6. Follow selling rules on when to sell and take your profit on the way up.

  7. Buy when market indexes are in an uptrend. Reduce investments and raise some cash if general market indexes show six days of increased volume distribution.

  8. Read IBD’s Investor Corner and Big Picture columns to learn how to recognize major tops and bottoms in market indexes. You can learn to do this.

  9. Buy stocks with a Composite Rating of 90 or more and a Relative Price Strength Rating of 85 of higher in the IBD SmartSelect Ratings. Run a checklilst on the top stocks on the IBD 50.

  10. Pick companies in which management owns stock.

  11. Consider boldface stocks on IBD’s New Highs List and Nasdaq Stocks On The Move.

  12. Select stocks with increasing institutional sponsorship in recent quarters.

  13. Current quarterly after-tax profit margins should be improving, near their peak and among the best in the stock’s industry.

  14. Don’t buy due to dividends or P-E ratios. Buy the No. 1 stock in an industry in earnings and sales growth, ROE, profit margins and product quality.

  15. Pick companies with a unique, superior new product or service that leads its industry.

  16. Invest in entrepreneurial New American companies. Pay close attention to those with IPOs in the past fifteen years.

  17. Check out companies buying back 5% to 10% of their stock and those with new management.

  18. Don’t try to bottom guess or buy on the way down. Never argue with the market. Forget your pride and ego.

  19. Find out if the market currently favors big-cap, mid-cap or small-cap stocks.

  20. Do a post-analysis of all your buys and sells. Post on charts where you bought and sold. Evaluate and develop rules to correct your major mistakes.

3 Additional Rules (Some of Brett’s Napkin Investing Rules)

  1. Never invest more than 10% of your total portfolio value in one stock. Diversification is key to building a stable well-balanced portfolio.

  2. Never follow the crowd. Conduct your own research and take the time to discover new investment opportunities.

  3. Follow the flippin Rules. It’s critical you follow the rules no matter what.

Step 4: Invest. Okay, you made it! I understand you may be confused right now because I gave you a bunch of information to digest, so take a deep breath and if necessary re-read steps 1 – 3 as many times as you need.

Before you invest, something to keep in mind is diversification. Just because you spent countless hours researching a stock, doesn’t mean you can’t lose money. As a general rule of thumb do not invest more than 10% of the total value of your portfolio in any one stock. Please stick with this rule even if you only have $100 in your brokerage account. Because over time your account will grow and you will have gained discipline.  Also, try to create a well-balanced portfolio of small-cap, mid-cap, and large-cap companies as well as investing in different sectors and industries and across different economics. Consider investing in fixed income securities, like corporate, U.S. Treasury, and or municipal bonds. We will review how to create a well-balanced portfolio in a later post.

Now go ahead and press trade, because you are ready to buy stock.

Step 5: Re-evaluate Your Investment Every Quarter. In my opinion, this is a critical step. Documentation of not only what we are invested in and how your investment went is essential, but our emotions and thought-process is crucial to developing into a stronger investor. I found this to be incredibly useful for me. Learning from my mistakes made me into a smarter more rational investor.

Another Thought. Thanks to new financial products like ETFs, you may find you want to invest in a specific country after researching Step 1, or even a particular sector like in Step 2, and now you can. You can use the ETF screener from your brokerage account, to find county and sector-specific ETFs. We will review the benefits to choosing an ETF over an individual stock in a later post.  

(I have not been paid to endorse any of the following resources; WSJ, The Economist, Citi GPS, and Investors Business Daily)

Opening A Brokerage Account

Disclaimer: This post contains affiliate links. This means I may earn a commission should you chose to sign up for a program or make a purchase using my link. Please know I only promote companies that provide value to you and help you get closer to being financially independent! If you have any questions, please let me know. I will always put you first and being transparent is a top priority.

Opening a brokerage account is one of the best ways to begin growing your money. This critical step will allow you to begin building wealth and the best part is, you can watch it grow from the comfort of your bed, or a beach (as long as there’s Wi-Fi). The goal of this post is for you to 1) understand what a brokerage account is, 2) learn about online brokers, and 3) how to open an account.

What is a Brokerage Account? Simply put a brokerage account is a user interface connecting you with different financial markets allowing you to buy and sell equities; more commonly known as stocks, like Apple, Google, and Ford Motor Company. Buying and selling equities is only one of many investment options you can include in your investment portfolio. A brokerage account will enable you to buy options, bonds, mutual funds, commodities, and foreign exchange securities.

The Players. Over the years competition of the online brokerage business has grown so fierce, that today we can buy and sell securities at almost no cost to you. And some companies are completely free, like Robinhood. This is great news for investors like you, because not only can your commission fees only cost a few dollars, but many online brokerage firms provide you with vast amounts of research, education, and tools to allow you to be more efficient and effective as you learn how to trade. Below, I have created a chart of some of the largest players in the online brokerage business, and others like Robinhood, Stash, and Acorn which are geared towards those who have never invested before.

Broker Comparison Chart.JPG

Fidelity, E-Trade, and TD Ameritrade all have fairly simple platforms and are recognized as some of the most popular online brokers today. This is largely due to their easy to use tools, great research, and education centers. The costs are small but this is only relative to how much you plan to invest. For example, if you plan to purchase $100 of XYZ Company, you will have to pay $4.95 in fees to Fidelity when you buy the stock and then another $4.95 when you sell the stock. Let’s say after one year XYZ Company increases 15% which translate to $115.  Not bad, but in reality, you earned $105.10 or 5.10% minus capital gains taxes. As a general rule of thumb, I would recommend investing at least $1000 in each stock if you plan to use one of these three platforms.

There is a way around paying a commission on sites like Fidelity and other large online brokers. You can purchase exchange-traded funds (“ETFs”). An ETF is similar to a stock in regards to how they traded and how we buy and sell them, but ETFs are not companies like apple and google. An ETF is a basket of different assets or stocks that track a specific index or sector. For example, the ETF SPY is an index that follows the S&P 500. If the S&P 500 index increases 1%, then SPY will increase by approximately 1%. ETFs are offered on virtually all asset classes and indexes ranging from traditional investments to alternative assets like commodities or currencies. Fidelity, E-Trade, and TD Ameritrade all offer over 250 different ETFs on their platforms. The only fee you will pay is on the underlying ETF. Every ETF charges a small fee per year. For example, if I purchase $10,000 of SPY, I will pay 0.09% on the value of the asset, which translates to $9 dollars a year. The 0.09% fee goes towards the administration and maintenance fees.

Over the last few years, new players have emerged in the online brokerage business such as Stash, Acorn, and Robinhood. These companies have and continue to create innovative products for investors who only have a few dollars to invest at a time. The goal of Stash is making investing so simple, anyone at any age can participate. Stash has a cool investment feature where you invest based on your interests and personality. If you’re a Techie, stash has ETF’s that specifically invest in technology stocks. Or if you like eco-friendly companies, Stash has an ETF focused on companies that produce solar, wind, and other forms of renewable energy. Stash has investments for everyone and provides investors with an easy understanding of what they are investing in.

One of my favorite products which Stash and Acorn allow you to participate in is buying fractional shares. If you only have 20 dollars to invest and you want to buy Amazon, which is currently trading at around $1,800 a share, you can. You would never be able to purchase this on Fidelity, E-Trade, or TD Ameritrade since you only have $20. But you could buy $20 worth of Amazon on the Stash and Acorn platform. You would own 1.11% of one share and should amazon increase 10% after one trading session, you will earn 10% as well on your investment.

Another innovative product Acorn has introduced is something called “Round-Ups”. A Round-Up is the spare change captured from rounding up every transaction to the nearest dollar. All you need to do is link your credit and or debit card to your Acorn account. For example, l just purchased a cup of coffee for $3.50, Acorn will charge me another $0.50 and add it to my Acorn account. Once I build up $5, Acorn will automatically invest the $5 for me. This is one of my favorite features of Acorn because it’s an easy way to invest and grow your money without you even realizing it. The “Recurring Investments” feature is another great way to grow your wealth. Acorn automatically takes a specified amount from your checking or savings account each day, week or month and invests it for you. Fidelity, E-Trade, and TD Ameritrade also have this feature and I personally use it. “Round-Ups” and “Recurring Investments” are great ways to build wealth all while having a minimal impact on your life.

Okay so now that you know what a brokerage account is, and some of the cool features they have, let’s open one up.

Opening your Account. After you decide which brokerage platform fits your individual needs, it’s time to open one. I would recommend considering opening two accounts. Let say you open a fidelity account for your more serious, larger investments, and use the “Round-Ups” feature from Acorn, so you can easily save and invest every time you use your credit or debit card. 

Before you open your account you will need the following items:

·         Social Security Number or Individual Taxpayer Identification Number

·         Foreign Tax ID, passport, or visa number (if you’re not a citizen or permanent resident of the U.S.)

·         Employer’s name and address

Don't worry if you're in high school or college, as long as you are at least 18 years old you can open one. And if you're a hungry teenager like I was, your parents can set up a custodial account so you can trade as well. Once you have these documents, opening an account is very simple and each brokerage platform takes you through the process in under 10 minutes. So go ahead and give it a shot. Please let me know if you have any questions or comments, by writing below or to brett@brettsnapkin.com and I’ll be happy to help you.