Should you invest in a stock, choose a successful Mutual Fund or buy an ETF (Exchange Traded Fund)? The age old argument persists. Some experts promote the picking of individual stocks, while others, advocate investing in either Mutual Funds or ETF's. Let’s explore which option is best for you. As an investor, you should understand the risks and benefits associated with each so that you can make an educated choice.
What are stocks, Mutual Funds, and ETFs?
The stock of a company refers to the total number of shares into which its ownership is divided. When you buy shares of a company, you become a part owner of it in proportion to the number of shares you buy. For instance, if you buy a hundred shares in a company with a total number of a thousand shares outstanding, you will have a claim to 10% of the company’s performance. The advantage of owning shares in a company is that it gives you voting rights, the ability to receive dividends when paid buy a company, and the right to sell your shares to someone else (hopefully at a higher price than you bought them for).
Mutual Funds and ETFs, though not without their differences, are similar in their concepts. Mutual Funds take investments from many investors and diversify those investments into different stocks. Mutual Funds are professionally managed and are classified based on the principal financial asset in which they invest. Thus, there are fixed income or bond Mutual Funds, stock funds, and hybrid funds (a combination of stocks and bonds).
Exchange Traded Funds (ETFs) are similar to mutual funds in that they invest in many different stocks or sectors of the market. However, ETFs sometimes track an index such as the Standard and Poor's 500 (SPY), the Dow Jones (DIA), or the Nasdaq 100 (QQQ) and are similar to stocks in that they are traded on U.S. stock exchanges. One can say that an ETF is a mutual fund that trades like a stock.
Picking individual stocks gives an investor the benefits of high liquidity and the complete freedom to choose the companies he/she wants to invest in. There is also the advantage of tax efficiency as the investor can decide when to buy or sell his stocks. When buying and selling a stock you will incur a commission charge from your broker. Individual stocks do, however, carry more risk than investing in mutual funds or an ETF as a stock is not diversified. Also, investing in a stock is more time-consuming as the investor has to do all the research his/her self unless they use the services of a full service brokerage whom charge a fee for that luxury. Investing in a single stock means the investor will not be successfully diversified thereby magnifying his risk of picking a losing stock.
On the other hand, Mutual Funds have as their primary advantages the fact that they provide the investor a very high level of diversification, carry low investment minimums (in the range of $1000), and they are professionally managed. Some disadvantages of Mutual Funds are that they have lesser tax benefits as capital gains taxes are incurred every time the shares within the funds are traded. They also incur expenses such as management fees. Some management fees are charged when entering the Mutual Fund, while others are charged upon liquidation of the fund. Also note that Mutual Funds are traded at the closing price of the day which make them less liquid than stocks.
ETFs, on the other hand, provide long-term investment returns with higher diversification than stocks and a lower fee than Mutual Funds. Unlike Mutual Funds, they are tax-effective because you incur capital gains taxes only when you sell them. Moreover, ETFs do not trade only at the end of the trading day like Mutual Funds; ETFs are available for trading all throughout the trading day. Since trading ETFs are like buying and selling individual stocks, they do not incur any management fees (only commission charges) making them more cost-effective than Mutual Funds.
Each of the investment vehicles described have their pros and cons. If you are someone who wants to be in charge of your investment decisions and portfolio, picking individual stocks may be for you. If you do not mind incurring management fees and being hands off with your investments, you can go for an actively managed Mutual Fund. Finally, if you desire attractive investments with low costs, tax efficiency, and stock-like features, you should consider ETFs.