If you were to jump into a Canadian lake in January, I bet you’d feel some sort of shock to your system.
If you’ve never done much investing, you’ll feel a similar shock when you start to sort through all the investing options.
In fact, beginning investors often use phrases like - overwhelmed, so many choices, and I don’t know what to do.
Don’t expect me to tell you what to do, but I do plan to help you understand some important terms and investment vehicles so you can continue investing with confidence.
These three important terms are index funds, mutual funds, and ETFs.
In addition to this guide I suggest the beginner’s guide for newbie investors.
A Basic Primer on the Stock Market
When you buy a stock, you are buying a part of a company. When that company succeeds, your stock value increases. When things are waning, your stock value will likely decrease.
Index funds, mutual funds, and ETFs are all ways to own stocks (or even bonds, but we won’t focus on that now).
You can, if you’d like, buy a stock for a select company. Personally, I’ve used ShareBuilder when making those types of transactions (they even give you $50 when you sign up).
However, buying single stocks can be dangerous because you are not diversified. This means all your eggs are in one basket, and if your stock goes down, so does all your investment.
Thus, index funds, mutual funds, and ETFs are all common ways to diversity your investment. You buy shares for each of these types of investments from a broker. Due to low prices I recommend online stock brokers if you are doing your own investing. Remember, you can often get bonus goodies when signing up for a new online brokerage account. A current example is the free Dell 24” monitor at OptionsHouse.
Now, let’s learn a little more about …
Index Funds, Mutual Funds, and ETFs
The Index Fund
The goal of an index fund is to own all or most of the stocks represented by a certain part of the stock market.
Take the S&P 500 Index Fund as an example.
The S&P 500 represents the largest 500 publically traded companies. If you have $1,000 to invest, it wouldn’t be prudent (due to buying and selling costs) to buy shares for all of those 500 companies. However, if you were to buy a S&P 500 index fund, in that single transaction you would actually be buying stocks for those 500 companies.
Consider the fruit basket, as an example. You could go the the grocery store and buy an apple, an orange, a banana, and a grapefruit. Imagine that you would be forced to pay for each of those fruits separately. That would be annoying, right? However, you could buy a basket that has an apple, an orange, a banana, and a grapefruit, and checkout once for all of those items.
That’s what you do when you buy an index fund. You buy a little bit of all of the companies represented by the company.
Now, you need to remember that index funds track different indexes. Some will track big companies and some small. Some will buy international companies.
Since index funds own a little of all stocks in the index, their goal is not to beat the market, but simply to average returns consistent with the market.
A hallmark of index funds is very low operating costs so more of your money is in the market.
The Mutual Fund
The goal of the mutual fund is to own only the best performing stocks because they want to beat the market.
Consider the fruit illustration once again. In this case, let’s say a shopper has heard that grapefruit are in low supply. She decides to buy extra grapefruit because she thinks they will be more expensive the next week. She doesn’t get a little of everything – she just picks the winners (or what she thinks will win).
When you buy a mutual fund, the fund manager will use the money you invest to buy what he, she, or they think will be the winning stocks. If they are right, your investments go up. If they are wrong then your investments will go down.
Now we meet the latest rock star in the investing world.
An ETF can have a strategy like a mutual fund (actively managed fund) or an index fund (passively managed fund).
The biggest difference about these little guys is that they are the easiest to buy and sell. Many brokerages will allow you to buy them free of charge, and they can be bought or sold at any time of the day.
ETFs are the absolute best for those with a very small starting investment. With $100 (or less), you can get started buying ETFs. Many index funds require that you have anywhere from $1,000 to $2,500 to start in a single index fund. Thus, with $1,000 you can get much more diversity with ETFs than you can with index funds.
Which is the best way to invest?
I’ve previously compared index funds to mutual funds.
Here’s a list of questions and answers suggested in this Christianpf article (written by a guy named Craig Ford – sound familiar?):
- Do you like to do a lot of investment research and analysis? The stronger you answer no, the better an index fund becomes.
- Do you need a fund that, for tax reasons, has less buying and selling (short term gains)? The stronger the yes, the better an index fund becomes.
- Do you have a lot of money to start investing? The less money you have, the more you should look at ETFs. This is especially true if you use something like Charles Schwab that offers fee free ETFs.
- Do you like a more aggressive investing strategy? The stronger the yes answer, the more you should look at mutual funds.
- Do you know a lot about investing? The less you know about investing, the safer you will be using index funds until you have a chance to learn how to start investing.
- What investing strategy do you use? Do you buy funds once a year, do you dollar cost average, or do you use a value averaging investment strategy? The more frequently you trade, the more you should look at ETFs as they typically have the lowest trading fees. Check with your broker for the exact fees.
At least now you should know the difference between your investing options so you can proceed with confidence.