#WealthforLife Wednesdays: Learn About ETFs, Mutual Funds and Stocks

What's the difference and how do I choose which is best for me?

dominique broadway 

“The best piece of financial advice I got was to invest in what I know and that slow and steady wins the race,” says financial advisor and coach Dominique Broadway. “Most people don’t want to hear that, but its true.”

An employer sponsored plan, such as a 401(k) or 403(b), are most people’s first foray into investing. The process is simple: You designate a percentage or an amount you want to be deducted from your paycheck, select your asset allocation based on your time horizon and risk tolerance, and then your employer invest the funds on your behalf. This is a great tax-deferred vehicle to save for your golden years, but when contributing to your employer sponsored plan the options are limited and the administrator decides what you can invest in. Broadway says that if you want greater control over your investments, are maxing out your 401(k), or feel like you are contributing enough and want to diversify your investment portfolio, it’s time to start looking at other vehicles.

But she warns, “before you start investing you should have at least 3-6 months of emergency cash reserves.” For example, if your monthly expenses are $3,000 a month you would need $9,000 to cover your expenses for three months. (Read more about how to create a realistic budget.)

She recommends these options if you’re looking to start investing outside of your employer sponsored plan:

Exchange Traded Funds (ETFs)

What is an ETF: ETFs track broad market indexes (stocks from companies of all sizes; large, mid and small cap) such as the S&P500, NASDAQ-100 index, Dow Jones, etc. Just like any other publicly traded company they have ticker symbols. For example, The SPDR ETF is designed to track the S&P500 index (NYSE: SPY)

How they work: ETFs trade throughout the day and can be bought or sold anytime the market is open. Although they have been around since the early 90s, ETFs have become a really popular option in recent years due to their tax efficiency, low cost and stock-like features, says Broadway.

“They work very similar to a mutual fund but the only difference is that they trade like a stock.”

How do I buy an ETF: An ETF can only be traded through a stockbroker.

“Look into low-fee or discount brokerage firms such as Sharebuilder, E-Trade, and Vanguard, just to name a few. Their fees and commissions are significantly lower than a full-service brokerage firm,” she adds.

How much money do I need to invest: Broadway recommends that ETFs be purchased in larger lump sums of cash such as in denominations of $500, $1000 or more. Since ETF’s must be purchased through a broker, commission fees can seriously eat away at your investment. For example, if you invested $100 a month and it cost $10 to trade, that means that you have already lost 10% of your investment. The fund would have to have a 10% return just for you to recoup your buying cost. Remember, you also will pay a commission when you sell your ETF. For investors interested in contributing smaller amounts such as $25 a week or $100 a month or who invest on a more sporadic basis a mutual fund may be a better option for you because the fees will be lower.

Mutual Funds

What are they: A mutual fund is similar to a stock, but instead of investing in one company you are investing in hundreds of companies Broadway explains. “Some mutual funds can have 50 different companies in it and some may have a couple hundred different companies. This allows you to diversify your risk.” Because your overall risk is spread out, if one asset class performs poorly your loss may be tempered by an investment in another asset class.

How do I buy a mutual fund:Mutual funds are managed by a team of managers or a professional fund manager who makes the investing decisions explains Broadway. A mutual fund can be bought through low-fee brokerage firms such as Sharebuilder or through a full-service brokerage firm.  She recommends that when investing in a mutual fund be sure to read the funds prospectus, which contains key information about a fund such as its investment objectives, goals, strategies, the risk of investing in the fund, fees, expenses, past performance, etc. More detailed information can be found in the companies statutory prospective such as how to purchase and redeem shares. ”Pay close attention to the fees,” advises Broadway. Mutual funds come in two flavors: a no-load mutual fund and a load mutual fund. No-load means that you can buy and sell a mutual fund with no commission fees or sales charge. Be sure to read the fine print because some brokerage firms and banks charge their own fees. A load fund charges you for the shares purchased, typically 4-8%,and an initial sales fee.

How do I choose a mutual fund: “It depends on what company you are investing with, the goals and the time frame that you will need your money” says Broadway. “For example if you are investing with Vanguard you can take an eight question quiz to determine your risk tolerance and investing expereince and they can then help you determine what type of mutual fund is best for you. Other brokerage firms such as Scottrade also have a risk quiz.

How much do I need to get started: There are a lot of funds that have a minimum investment of $500 and some even $5,000 but those minimums can be reduced to as little as $25 if the investor agrees to automatic or reoccurring deductions from a checking or savings account to invest in the fund Broadway explains.

Stocks

What is a stock: “A stock is an investment in a company. When you buy a stock you are buying a share of a company and are investing directly in that company,” explains Broadway. You make money on a stock two ways. You can be paid a dividend (a payout generally made to shareholders every three months regardless of how the stock is performing) or when a stock appreciates in value. Stocks fluctuate throughout the day so it is tough to gage how much you will really make until you sell.

How much money do I need to invest: Stocks can be purchased through a full-service broker or a discount brokerage firm. Some full-service brokers charge a flat fee but many will charge 1.0% to 1.5% of the dollar amount of the stock purchase. (A $5,000 investment would cost you $50.) A discount brokerage firm offer traders for under $10 regardless of the size of the trade explains Broadway. (For example, A $5,000 investment using E-Trade would cost you $9.99; Sharebuilder $6.95.)

How do I choose a stock to buy: Broadway recommends “investing in what you know and things that you use.” Websites such as MarketWatch will help you to research past performance of the company, gain an understanding of the company’s history, future plans and new products to be released, if the stock has been experiencing growth, etc. Broadway recommends looking at a company’s performance over the past five years or even 10.

Risk: Historically, stocks have produced long-term gains and may be your best bet for beating inflation, but Broadway says that unless you have larger amounts of cash to invest and are willing to lose, such as $30,000-$50,000, she does not recommend investing in individual stocks. Unlike a mutual fund, if the company tanks there are no other funds to offset your loss.

Dominique Broadway founded Finances Demystified in 2012. The organization focuses on provoking conversations about money amongst young professionals. Through bootcamps and her #SocialMoneyMedia tour she holds discussions on cash flow management, risk management, retirement planning, investment management, estate planning, college planning and debt management.

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