When it comes to getting in shape physically, there are different weights that a person can use to achieve their physical goals. Depending on your particular body goals, a person will work with varying weights. Regardless, it usually results in the same goal: getting stronger, building muscle, and getting in shape overall. This is also true when using different investment vehicles such as stocks, mutual funds, and ETFs.
Stocks, mutual funds, and exchange-traded funds (ETFs) are all investment vehicles, but they have distinct characteristics that appeal to different investors. All three investment vehicles help investors grow their money over time. It is important to know the difference between the three. In this blog, I give a basic comparison of the three.
Stocks:
Ownership: When you buy stock, you purchase ownership in a specific company. Purchasing a company's stock allows you to become a shareholder and participate in the company's profits and losses. Stocks can be traded throughout the day.
Risk: Investing in individual stocks can be riskier than investing in mutual funds or ETFs because the success of your investment depends solely on the performance of that particular company. Stock prices can be highly volatile and fluctuate throughout the day. Individual companies can face various risks, such as competition, market trends (supply and demand), political events like war, trade tariffs, and regulatory changes. Due to these facts, estimating what type of returns you will receive over time is hard.
Potential for Returns: Stocks offer higher returns than mutual funds or ETFs, especially if you invest in successful companies that experience significant growth. Stock gains outpace inflation over time, keeping your money from losing its purchasing power if you sell your stock for a profit. However, high-return stocks usually come with higher risk, and lower-risk stocks typically come with lower gains.
Diversification: Achieving diversification with stocks typically requires investing in multiple companies in different sectors and industries, which requires significant effort, research, and money. For example, having stocks in various sectors, such as consumer staples, energy, financials, healthcare, etc, allows the investor to hit different industries of the economy. Each sector has pros and cons, and diversifying in the sectors creates a form of balance within your portfolio. Another way to ensure diversification is to invest in defensive-type stocks (noncyclical stocks), which are companies that remain relatively stable during economic downturns. Due to their low risk, defensive stocks' swings in losses and gains are not as significant as those of other stocks. Examples of defensive stocks are Coca-Cola (KO), Johnson & Johnson (JNJ), and Altria Group Inc (MO). On the other hand, you have stocks that are considered cyclical, in which the returns follow the economic cycle. Cyclical stocks typically have higher returns, meaning that your gains will reflect when the stock market and economy are well. Stocks such as Expedia (EXPE), Ford (F), and Intel (INTC) are examples of cyclical stocks. The combination of defensive and non-defensive companies and companies in different sector groups, such as consumer staples, information technology, energy, financials, etc., creates a stock portfolio that touches each part of the overall economy. Note that buying many individual stocks can become costly over time.
Management: Investors who buy individual stocks must actively manage their portfolio, including researching companies, analyzing financial statements, and monitoring market trends if they are do-it-yourselfers (DIY). This requires a lot of work and learning the market. Of course, investors can hire a financial advisor to manage the stock portfolio.
Mutual Funds:
Ownership: Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities. Investors own shares of the mutual fund, not the underlying assets. Many American workers put their retirement funds into mutual funds through employer-sponsored retirement plans such as 401ks, 403bs, Simple IRAs, SEP IRAs, TSPs, etc. Mutual funds trade once a day after the market closes.
Risk: Mutual funds spread risk across a diversified portfolio of assets, reducing the impact of poor performance by any single security. For example, a decline in one sector can be offset by gains in another, making the benefits of investment diversification real and concrete. However, losses are still possible, particularly if the overall market or specific sectors experience downturns.
Potential for Returns: Mutual funds offer potential returns based on the performance of the underlying assets. The returns depend on the fund manager's investment decisions and the overall market's performance. Returns also depend on the overall goal of the particular mutual fund's objectives, such as long-term or short-term outlook and risk associated with the mutual fund.
Diversification: Mutual funds inherently provide diversification since they invest in various assets. This diversification helps reduce risk compared to investing in individual stocks. For example, a mutual fund can have 40 different stocks, 10 different short- and long-term bonds, and cash in one mutual fund. Because of the structure of a mutual fund, an investor can have access to more stocks and bonds at a lower price than if the investor purchases the stocks and bonds individually, which can be costly.
Management: Mutual funds are managed by professional portfolio managers who make investment decisions on behalf of the fund's investors. Portfolio managers will add new stocks and bonds and remove stocks or bonds that are not performing well for the mutual fund. Because portfolio managers make the investment decisions for the mutual fund, investors pay management fees and expenses for this service.
Exchange-Traded Funds (ETFs):
Ownership: ETFs are investment funds traded on stock exchanges, similar to stocks. When you buy shares of an ETF, you're buying ownership in a portfolio of assets managed by the ETF provider. ETFs are also considered a pool of investments, similar to mutual funds. The main difference is that ETFs trade like stocks, not like mutual funds.
Risk: Like mutual funds, ETFs offer diversification across a range of assets, reducing the risk compared to investing in individual stocks. The pool of assets in the ETF reacts to the market as any other investment. Because it is a pool of different assets, a decline in one sector can be offset by gains in another. However, the risk level can vary depending on the underlying assets held by the ETF.
Potential for Returns: ETFs offer potential returns based on the performance of the underlying assets. They often track a specific index, sector, or commodity, allowing investors to gain exposure to a particular market segment. For example, an investor can purchase an ETF that only includes oil and gas company stocks, which is called a sector ETF. The potential returns will be based on the performance of the oil and gas sector company stocks within that ETF.
Diversification: ETFs offer instant diversification since they typically hold a basket of securities. Investors can access a broad range of assets through a single investment. Like mutual funds, ETFs can have different types of stocks, bonds, etc., to create diversification in a single fund. Sector ETFs include healthcare, finance, real estate, consumer staples, etc. ETFs give you a broader range to diversify your portfolio.
Management: ETFs are mostly passively managed, meaning they aim to replicate the performance of a specific index, sector, or benchmark. As such, they generally have lower management fees than actively managed mutual funds. Actively managed ETFs typically do not target an index of securities but rather have portfolio managers decide which securities to include in the portfolio, which can lead to higher management fees.
Considerations:
Risk Tolerance: Stocks may be suitable for investors with a higher risk tolerance and the time and expertise to research and manage individual investments. Mutual funds and ETFs may be more appropriate for investors seeking diversification and professional management.
Cost: ETFs often have lower expense ratios than mutual funds, making them attractive for cost-conscious investors. However, trading ETFs may incur brokerage fees.
Liquidity: Stocks and ETFs trade on exchanges throughout the trading day, offering liquidity for investors to buy and sell shares. Mutual funds typically have a once-daily liquidity feature, where transactions are processed at the end of the trading day.
The Take Away
Ultimately, the choice between stocks, mutual funds, and ETFs depends on individual preferences, risk tolerance, investment goals, and the time and effort one must dedicate to managing their investments. Many investors choose to hold a combination of these assets to achieve diversification and meet their financial objectives.
Consulting with a qualified fee-only financial advisor is recommended to ensure you make an informed decision about investment and portfolio planning appropriate for your specific circumstances.
The information herein is intended for educational purposes only and is not exhaustive. Diversification or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your situation.
FINRA has not reviewed this content.
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