The investment world may seem overwhelming at times, understandably so. There are enough fancy new terms added each year by experts and gurus holding new acronyms and titles to baffle the general public into submission. Allow me to add two comforting assertions to the matter. First, a simple statement made in a complex way does not make you dumber or the author smarter. Second, basics are just that, basics.
I’d like to address some very basic, but often misunderstood, terms within investing. Upon hearing different opportunities, prospective investors knee-jerk response is, “Well, which has a better rate of return?” As a CFP, I’ve fielded this question countless times when mentioning a particular account type or asset type. Remember, an account type (i.e. Traditional IRA, 401(k), Joint, etc.) are only accounts, think of it as the bucket you’ll be adding ingredients to. Similarly, a stock, mutual fund, or exchange traded fund is a type of asset, not indicative of a particular investment and its return.
Let’s start with the original and underlying ingredient for the rest of our discussion. A stock is a share of ownership in a company that may be purchased by the investor. This term could be applied to two brothers splitting up their shares of ownership in their pizzeria, or a billionaire buying a portion of Tesla. For the purposes of this article, we’ll focus on publicly traded stocks. Aside from a potential brokerage commission or trading fee, holding a stock usually does not come with an ongoing fee or management expense. The investor is completely vested in the ups and downs of that particular company. As one could gather, the question, “Do stocks have a good return or bad return?” is not entirely fair. For example, a share in Amazon may have had better performance over the past few years than a share in Macy’s, but they are both stocks. There are currently about 3,530 investable stocks in America to choose from.
A mutual fund is a professionally managed pool of money collected from many investors and invested across diversified holdings. These holdings can include, stocks, bonds, and cash, and together make up the fund’s portfolio. The two main benefits touted by the industry would be allowing modest investors broad diversification and professional management. For example, an investor would have to shell out $3,318 to buy just one share of Amazon today, but the same investor could use that money to buy nine shares of VFIAX (Vanguard’s S&P500 Index Admiral Shares) and gain immediate exposure to 509 different companies. Unlike stocks, mutual funds contain fees in the form of “Loads” and management expenses. Some experts argue these fees are warranted in higher performance in good years and less downside in bad years, while others posit many funds have done no better than their benchmarks or have even underperformed in certain situations. The oldest mutual fund still in existence would be the Vanguard Wellington Fund, which debuted in 1929. Nowadays, there are roughly 8,000 available mutual funds in the United States, so naturally, investors have experienced different successes and failures.
Exchanged traded funds were created in the 1990’s and have certainly been all the craze in recent memory. They are similar to mutual funds as far as being a diversified pool of investors’ money, but they trade throughout the day like stocks, as opposed to mutual funds that are bought and sold based on their price at day’s end. Most ETF’s are passively managed and track an index, and have lower expenses than mutual funds. The trend towards ETF’s is apparent, as evidenced by last year’s inflow/outflow disparity. Through September 2020, outflows from mutual funds totaled $317 billion over the year, whereas inflows into ETF’s were $313 billion during the same timeframe.
These three terms may be basic, but they are important pillars of the investing world, and cannot afford to be confused amidst the financial jargon found on the internet or 24/7 business channels. Investors should now realize that one asset type does not provide a surefire better return than the other, similar to the account type discussion. An apparently expensive mutual fund made up of tech stocks likely did far better last year than a cost-efficient ETF made up of oil stocks. But be careful of ever casting a broad generalization, inside the same tech run of 2020 that Apple gained 77%, there were companies like Xerox that lost 37%.
Please note, past performance does not guarantee future results.
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