A Primer on Stocks, Bonds, Mutual Funds, and ETFs
At a first (and second) glance, investing can appear very overwhelming. There is a wide variety of asset classes to choose from, the risk of losing money, and not to mention the daunting task of predicting the future. It’s like this: you know you want to have a return on your money, but when it comes to choosing the specific asset to get you there, you’re lost.
We want to help you make sense of it all. While this won’t tell you which specific stocks to pick, it may help you determine the types of assets you want in your portfolio. As an investor, it’s important to understand what you are investing in and what comes along with it. Here, we’ll address stocks and bonds and the different vehicles that bundle them together: mutual funds and ETFs.
Stocks
When you purchase stocks, you are buying a piece of a company. For the business, this is a popular way to raise capital. Your percentage ownership in a company is measured in units called shares. Shares decrease or increase in value depending on many factors such as the news, the economy, or the overall health of the company. Because the value of these securities can be affected by so many outside influences, stocks are generally considered to be a risky investment. The tradeoff is that they also offer investors the potential for a higher return.
The goal of investing in stocks is either to receive recurrent income in the form of dividends or to make a profit by selling your shares at a higher price than what you initially paid for them.
Bonds
Another way companies, or even the government, raise funds is by issuing bonds. When you purchase a bond, you are lending your money to a business in hopes that they will pay you back at the date of maturity. Plus, they’ll make interest payments to you along the way. These payments are one of the reasons bonds are also known as fixed-income securities.
Bonds typically have a lower rate of return than stocks and are usually less risky because companies have a contractual obligation to repay their debt to you. Compare this to stock ownership, where an investor owns shares with no guarantee their value will increase. Also, if a company goes bankrupt, they may make an effort to repay their bondholders, but likely won’t owe their stockholders anything. This decreased volatility in the bond market means that when the stock market experiences a downturn, bonds prove to be more stable. This makes them good securities to purchase if you are looking for a way to limit the amount of risk you are taking on in your portfolio.
Mutual funds and ETFs
Some of the ways to purchase stocks and bonds are through mutual funds and exchange-traded funds (ETFs). These “fund companies” pool money from many investors to purchase a bunch of different types of investments that will make up the fund. Think of a fund as a bucket that is full of different securities. When you invest in a share of the fund, you own a percentage of everything inside the bucket. These funds are attractive because they offer diversification, fund management and provide a good choice for non-institutional investors.
Why is diversification good?
The point is to find securities that are negatively correlated so when one goes down the other is going up. For example, think of stocks and bonds as sunglasses and umbrellas. When it’s a beautiful day outside, sunglasses are a popular item to buy. However, when there is a thunderstorm people flock to umbrellas, and the sales for sunglasses drop. If you are only invested in sunglasses, every time there’s a rainy day, your portfolio assets will drop in value. However, if you are invested in both sunglasses and umbrellas you may be able to capture a positive return from each day; rain or shine.
The difference between mutual funds and ETFs
Generally, mutual funds allow investors to leave the hard work and security selection to the professionals. Many mutual funds have managers who perform analyses and operate the fund for a fee. Management fees and other expenses for marketing, commissions, or “exit fees” may be incurred when you buy or sell shares. An active manager tries to beat the market by making frequent trades, while a passive manager seeks to replicate a broad market and match the performance of its benchmark. You can learn more about your fund’s investment policies and practices in its prospectus.
Exchange-traded funds typically have a passive investment strategy, which keeps fees low. They also trade continuously on exchanges, similar to stocks, and unlike mutual funds, which can only be bought or sold once at the end of each day.
Based on what you know now, you should be better equipped to select your investment vehicles. No one can guarantee you’ll earn your desired return, but you can certainly better educate yourself to make smart decisions. Remember to take into account the risk involved, fees, diversification, and your personal goals.