Today we will be concluding the “Investing 101” series with Part 3, looking at the various types of investments available on the market today (to read Part 1 on the market, click here, and for Part 2 on types of investment accounts, click here). It is a common but costly mistake to assume that once you have deposited your money into your investment account, it is automatically set up to earn returns for you. That may be the case with cash accounts (i.e. checking, savings, money market accounts, and CDs), but not so with retirement and brokerage accounts. In fact, if you do not take the time to set up your 401(k) or IRA when it is first opened, your deposits will likely just sit in a cash or money market account making close to 0%! It is crucial to make sure that your new account is set up to automatically invest in the investments you choose, or that you are controlling where your money is being invested.
Many investors prefer to exchange stocks, which can be bought through countless brokerage firms and financial institutions. As we previously discussed in part 1 of this series, stocks carry a significant amount of risk, being solely dependent on the performance and financial health of the corporations that issue them. The Great Recession in 2008 and 2009 saw the fall of giant companies like Lehman Brothers and General Motors. The more recent market crash in March 2020 during the height of the panic surrounding COVID-19 greatly disrupted the travel industry as flights and travel came to a screeching halt. The bankruptcy of corporations can be devastating to investors who hold a large portion of those corporations’ stocks in their portfolios. Financial crises tend to highlight the risk of stocks, but nearly any corporation’s stock is susceptible to a high level of volatility in price based on a number of factors. As such, individual stocks in one’s portfolio are one of the most risky types of investments. This volatility is also what makes stocks so appealing to investors: the potential for high return on investment (ROI).
Investors who capitalize on the intra-day and short-term fluctuation of stock prices are commonly known as day traders and swing traders. However, there are many alternatives to accessing the high return potential of stocks while being more diversified, which can reduce risk. Two of the most popular such investment products today are mutual funds and exchange-traded funds (ETF’s).
A mutual fund is essentially a bundle of securities (stocks, bonds, or alternatives) that usually has a certain investment objective or target. Mutual funds have been around since the 1920’s, and there are now thousands of mutual funds. Some mutual funds that seek higher performance hold only a few dozen stocks, while others that offer broad exposure to the market can contain thousands of stocks. Some mutual funds seek to target the performance of a certain sector of the market like technology or bio-medicine, while others seek to track market indexes like the S&P 500 or Russell 2000. The term “mutual fund” is such a broad category that it can further be broken down into actively-managed mutual funds, and passively-managed mutual funds (also known as “index funds”). Actively-managed mutual funds, as their name implies, are overseen by a manager or group of managers who research, buy, and sell holdings to seek returns for their investors within a certain level of risk tolerance. Actively-managed mutual funds were once the most popular and common form of mutual fund available, but often had very high management expenses. Since the 1990’s and early 2000’s, these types of funds have largely declined in popularity due to the rise of passively-managed mutual funds, more commonly known as index funds. Index funds seek to track the performance of specific “benchmarks” like the S&P 500, or a certain sector of the market. Index funds are usually managed by a financial group or team within a company. Index funds involve much less calculation of risk, reward, and market research than actively-managed funds. Instead, they essentially “buy the market.” For example, an index fund tracking the S&P 500 more or less will hold the stock of the largest 500 companies in the US, weighted by market capitalization. Because of the more simple structure and management of index funds, these funds usually offer much lower fees than their counterparts in the actively-managed category.
There has been a long-standing debate among investors over the superiority of actively versus passively-managed mutual funds. Dave Ramsey, a leading financial guru known for helping people get out of debt, is a big proponent of actively-managed mutual funds, controversially claiming investors can achieve 12% annual returns using these funds. On the other side of the issue, John Bogle, the founder of Vanguard, famously opposed actively-managed funds due to their high fees and the large majority of the funds that did not beat a simple S&P 500 index fund. He strongly argued for the use of index funds, at a much lower cost, to help investors achieve market returns without risking beating or losing to the market. We will explore the pros and cons of actively and passively-managed mutual funds in a later blog.
One major benefit of mutual funds is the broad diversity they can offer to an investor’s portfolio. In particular, index funds which track a specific market sector or index can easily hold positions in hundred or thousands of stocks. This allows an investor to simply buy one fund and immediately have exposure to a vast array of stocks. If one company the mutual fund holds goes bankrupt, it is only one in a large basket of stocks. An investor holding a mutual fund will potentially be much less affected by that company’s fallout than an investor who held direct shares of that company. Diversification is one of the core principles of investing: spreading your capital across various types of investments and sectors of the market to reduce risk that comes from a concentrated position in one company or investment type.
Similar to mutual funds, exchange-traded funds (ETFs) are a relatively new and popular investment product that have gained massive popularity since the 90’s. ETFs are in essence the same thing as a mutual fund, a bundle of various securities that can be purchased in a single fund. The difference, as the name implies, is that ETFs are traded much like stocks on the open market, with their prices fluctuating throughout the day. Mutual fund shares, on the other hand, are purchased only after the market close and share price is calculated after the close of each business day. Mutual funds can also be purchased in any dollar amount, generally with a minimum investment dollar threshold (e.g. $3,000) before an investor can buy additional amounts of the fund. ETFs do not typically have a minimum investment threshold, but require whole shares to be purchased. For example, if an ETF has a share price of $50, the minimum an investor could buy of that ETF is one share for $50. More recently, investment apps like Robinhood allow investors to purchase fractional shares of ETFs and stocks, which is likely to become increasingly more common as consumers seek more investing options. ETFs are generally considered more tax-efficient for investors, which is worth considering if you plan to buy them in a taxable setting like a brokerage account.
Stocks, bonds, mutual funds, and ETFs are some of the most common investment options for the average medium and long-term investor. There are many more products offered, depending on the goals and interests of the investors. Short-term investors often trade options, which are a derivative of stocks, commodities, or other assets. A derivative is a fairly complex financial term that in short means a contract you purchase which derives its value from an underlying asset. An investor can buy a call option, which gives the investor the right to buy the underlying asset at a certain price on or before a certain date. The opposite of a call option is a put option, which is also a contract for purchase which allows the investor to sell the underlying asset at a certain price on or before a certain date. Buying or selling the asset under the right of the option is called exercising the option. The value of an option is depending on the fluctuation in price of the underlying asset and dependent also on the time left until the option expires on its given expiration date.
If you’ve stuck with us through these three parts of Investing 101, you should have a good start to understanding how the financial world works. There are lots of helpful resources online to help you navigate the various types of investment products out there. One great reference tool is Investopedia.com, which is sort of like the “Wikipedia” of the investing world. It doesn’t offer much in-depth analysis of investing and financial concepts, but it provides summary-level information on nearly any investing topic you can think of. If you have any questions, comments, or areas of investing you would like us to discuss, please send us a message (see the "Contact” link here) or subscribe below to stay informed about the latest published blog posts!
Disclaimer: The opinions and views expressed by the author do not constitute investment advice or recommendation, and are provided solely for informational purposes, and are not an offer to buy or sell any securities. Always conduct your own research and due diligence before making any investment decisions.