There are a variety of ways that you can become an investor and a number of different asset classes in which you can invest in. But for purposes of this blog post, I want to address 4 ways in which you can invest in stocks within the stock market.
When you invest in stocks or equities in the stock market, you become a shareholder of that individual company or fund. No matter how big or small your investment, you are now a part owner. But there are differences between each way you invest including fees, taxes, the way they trade and their inherent risks.
See below for a breakdown of each.
Purchasing individuals stocks involves investing in specific companies. You can purchase a number of shares in a particular company – an example of a company would be Microsoft or Apple. At that point, you would own a portion of that company and would be participating in the market “experience” for that one stock.
Investing in individual companies will require more research, understanding of their business and more engagement on your part than investing in the other types of investments I will note below. Why? Because investing in individual stocks inherently has a bit more risk. You have chosen to invest your assets in one thing – one company. With that, you are exposed to more concentration risk or as the saying goes, “putting all your eggs in one basket.”
But I also recognize that investing in companies provides a level of comfort, for some, because they feel they understand and know what they are investing in.
I enjoy investing in individual stocks that I consume, understand and see value/potential in. But typically do not like to see my portfolio or that of my clients with any more than 15%-20% of a portfolio dedicated to individual stocks and no more than 10% in one individual stock.
A mutual fund is where money has been pooled together to invest in a variety of investments (mostly stocks – but can also include bonds, gold, etc.). Mutual funds invest in a number of investments that have commonalities or specific goals that meet the requirements of the mutual funds investment strategy.
There are mutual funds that invest specifically in companies that are all part of a market index (see below for index fund), or companies that are of a specific region of the world (US, Europe, Asia, etc.), or companies that are in a specific sector or industry (like technology, health, energy, etc.), or that have an overarching purpose (like women led companies, energy efficiency, etc.).
The beauty of mutual funds is that you are effectively investing in a number of companies all at once by simply investing in one single mutual fund. You are exposing yourself to greater diversification and thus reducing your risk. So if you had conviction in the technology space/stocks – instead of picking 2 or 3 companies to individually invest in, instead you could invest in a technology focused mutual fund that will have invested in hundreds of technology driven companies.
There are both passively and actively managed mutual funds. A post for another day, but note that actively managed mutual funds have a much higher fee associated with them due to their active management.
An ETF is similar to that of a mutual fund in that it invests in a variety of investments with a specific purpose. But one of the major differences is that ETFs can be purchased and sold throughout the day similarly to a stock. Whereas a mutual fund transacts at the close of the market each day.
Many ETFs, but not all, track the performance of an index and are passively managed with a low expense ratio (they are cheap).
What is an Index? An index is basket of securities, investments, etc. that represent and measure the performance of a specific market. Three examples:
An index is simply used as a measure to determine the performance and overall health of a specific market. Individual investors and investment managers will also use indexes to track and measure their own portfolios performance as a comparison to the performance of the index.
You cannot go and invest directly into an index. But….there are two ways that you can invest in something that tracks and invests identically to an index.
An Index Fund – A type of mutual fund. An example of an index fund that tracks the S&P 500 Index is VFINX – the Vanguard 500 Index Fund.
An Index ETF – A type of ETF. An example of an index ETF that tracks the S&P 500 Index is VOO – The Vanguard S&P 500 Index ETF
The biggest difference between the two is how they trade. Index ETFs can be bought and sold all throughout the day where as index funds transact at a specific value at the end of each trading day.
Index funds typically have a minimum investment. In other words, you need $3,000 or $2,000 (or whatever the fund requires) as a minimum investment to be able to buy the fund. Whereas index ETFs typically do not have minimum investments.
Index ETFs expense ratios tend to be cheaper. Not by much, but cheaper nonetheless.
With index funds there may be fees associated with each transaction (purchase or sale) depending on the fund. Many financial institutions will provide you a number of free individual stock or ETF purchases or sales throughout the month and thus reduce your cost of investing. This will be very dependent on where you invest and whether or not you are given free individual stock and ETF trades at the financial institution you trade with. Worth looking into if you plan to dollar cost average into the market over time.
Don’t forget, it’s all about building on your foundation of financial knowledge. You will not learn everything in a day. But over time, you will become comfortable with all of these concepts.
I won’t make a suggestion for each and every one of you on which investment is best because it just simply depends. It depends how much you are investing, it depends what you are interested in investing in, it depends on what type of account you are investing in, your risk tolerance and time horizon, etc. BUT if you are just getting started….I think a great entry point into investing is through a cheap, liquid, ETF that invests in a specific index like the S&P 500.
Another great blog post to check out for beginning investors: What Types of Accounts Can You Invest In
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