New investors can sometimes be overwhelmed by the many decisions that they have to make when they first decide to invest in the markets. Even experienced investors can become confused when making decisions about which investment vehicle best suits their needs. Three of the most widely used investing vehicles are individual stocks, mutual funds, and exchange traded funds (ETF’s). Each of these methods of investing has specific risk and advantages that investors need to understand and evaluate before jumping in.
Individual stocks can be purchased through a full service broker, an online broker service or directly from the individual company through a dividend reinvestment program (DRIP). Investing in individual stocks is inherently more risky than investing in mutual funds or ETF’s. Investing in an individual stock can be a high risk high reward proposition. If a company goes bankrupt, the stock could become worthless, conversely if the company is successful the stock’s value could theoretically increase by a 100% or a 1000% or more.
When an investor purchases individual stocks it is usually their responsibility to maintain his or her own portfolio. This means that the investor will need to understand how to buy and sell stocks, as well as how to value stocks and manage portfolio risk. The investor will also need to carry out these tasks in a relatively rational and unemotional manner.
Advantages of individual stock ownership
1. The chance for outsized gains, which is something that is unlikely to happen through broadly diversified holdings offered by mutual funds and index funds.
2. Low commission rates and no fees.
Disadvantage of owning individual stocks
1. Volatility and increased risk.
Managing an individual stock portfolio can be highly rewarding, but investors need to consider that it can be work intensive and time consuming. Individual stock ownership may not be a good idea for a passive minded, or risk adverse investors.
A mutual fund is a collection of stocks that are selected by a fund manager. Many new investors make their first investments through mutual funds. Investing in a mutual fund requires less investment sophistication than investing in individual stocks or ETF’s. Mutual funds offer investors a wide range of investment options, ranging from sector funds, such as technology, energy or retail to commodities funds and foreign index funds. The four most commonly used types of funds are money market funds, stock or equity funds, bond or fixed income funds and hybrid funds.
There are 3 types of mutual funds: open-end, unit investment trust, and closed-end. The most common type of fund is the open-end fund. The shares of open-ended mutual funds are not traded on the open market and can only be bought from and redeemed with the mutual fund company, or one of its selling group members. Open-ended funds are required to buy back shares from investors at the end of every day.
While mutual funds are a good way to get started in investing, many experienced investors shun them because of the high fees and generally low performance.
Advantages of Mutual fund ownership
1. Investing in a mutual fund does not require a lot of time or research.
2. Investing in a mutual fund gives an investor diversification which lowers investment risk.
Disadvantages of Mutual fund ownership
1. Mutual funds often charge a variety of fees such as management fees, account maintenance fees and early withdrawal fees. High fees can significantly reduce investment returns.
2. Over the last decade mutual funds have generally performed poorly because of high fees and over diversification.
A tip for investors that like mutual funds but want to avoid high fees is to invest in index funds, which are passively managed and mirror market indexes such as the S&P 500 or the Willshire 5000 index. [See: Indexing with ETFs or Mutual Funds]
Mutual funds might be a good choice for passive investors that cannot devote the time to actively manage their portfolio. However before investing in a mutual fund it is imperative to study and understand the mutual funds fee structure and expense ratio. You can find out which fees your fund charges by reading the fee table in the front of the fund’s prospectus. The fee table can be secured directly from the fund company or, in most cases, by visiting the fund’s website.
Exchange Traded Funds
Exchange traded funds (ETF’s) are made up of a managed collection of securities. ETF’s are often targeted towards specific Indexes such the S&P 500 index or the Dow Jones industrial index. If an investor purchases an index that tracks the Dow Jones Industrial index, the returns of such a holding would be nearly equal to the profit or loss of the Dow Jones index during the same period of time. Since an index fund spreads the risk amongst the stocks in the chosen index, it is less risky than investing in individual stocks. ETF’s trade on a stock exchange like individual stocks, so when you buy or sell shares of an index fund, you incur a standard commission fee.
Advantages of ETF ownership
1. Investing in an ETF automatically provides diversification, which reduces investment risk.
2. Index funds can be traded on the open market like stocks, which means that there are no early withdrawal penalties, and commission fees can be controlled.
3. Index funds are less actively managed than mutual funds. Some rely on computer models and have no human input in trading decisions. The end result is that index funds have lower fee cost than standard mutual funds.
Disadvantages of index fund ownership
1. Since the funds often follow an index it is not possible to outperform them.
Each investor has their individual investment objectives and investment style. Passive investors with a low tolerance for risk will probably prefer to invest in mutual funds or index funds. Investors that want to avoid investment fees will avoid investing in mutual funds. Active investors that are willing to take a risk in the hopes achieving returns that exceed those of fund investors, will prefer to buy individual stocks. Every investor must evaluate themselves before choosing the investment strategy that will best meet their needs.
Darnell Brown is an accountant with over 20 years of auditing experience. He has worked in both the private sector and for the United States Government. He currently works as a freelance writer and has written numerous financial articles for the investmentunderground.com website.