If you’re an investor (or would-be investor), you may know of the 3 main ways to invest in the stock market – individual stocks, mutual funds and exchange-traded funds (ETFs). Each has its pros and cons and none is perfect for everyone.
To determine which approach is best for you, consider first what each is and how it works.
Buying and selling individual stocks can be complicated and time-consuming. It also gives you the best opportunity to make a lot of money. The opportunity to win big also comes with the risk of losing big.
You must be willing to do a fair amount of research. You can do the research on your own or use a service like FinanceBoards by WooTrader. FinanceBoards provides an easy way to gather all the financial data you need – company financials, technical charts, website seo metrics, social media data and more - and present it in an easy-to-digest-and-use form.
With mutual funds, many investors pool their money and hire a manager to invest the money according to predetermined objectives. Some follow a “growth” objective – others track an index like the S&P 500.
Funds that follow an objective are generally actively managed and cost more in fees. Index funds are passively managed and cost less. FinanceBoards has a Mutual Funds Holdings widget that can be helpful in learning about various fund options.
Exchange-traded funds (ETFs), like mutual funds, spread investments among many stocks. They are different in the sense they trade on major exchanges like stocks. You can buy and sell ETF shares anytime. Mutual fund shares must be redeemed.
ETFs are primarily indexed investments meaning they are passively managed. A few ETFs are actively managed.
You likely need $10,000 or more in starting capital to invest in individual stocks. That’s because you need a diversified portfolio of stocks to guard against loss and to avoid having commissions eating up all your funds.
Many people start out by investing in mutual funds, which require as little as $500 or $1,000. Although ETFs have no minimum investment (other than the cost of one share), they do incur trading commissions just like stocks.
With stocks and ETFs, shares trade and prices change throughout the day. Mutual funds are traded between investors and the fund and priced at the end of the day.
Both stocks and ETFs can be sold short, something of interest to traders but not necessarily long-term investors.
Trading stocks or ETFs involve not only the cost of the shares, but also a commission. It’s wise to research this because the extra benefits offered by each brokerage vary greatly.
Mutual funds charge a management fee. As with commissions, management fees can eat into profits (earnings). Indexed ETFs have management fees as well but they tend to be very small. It’s important to compare all commissions and fees before deciding how to invest.
With individual stocks and ETFs, you don’t pay taxes on capital gains (profit) until you sell your shares. With stocks and ETFs, you can choose when to take a gain or loss (by selling) and thereby gain a tax advantage.
With mutual funds capital gains are spread among all investors and you have no way of knowing when the fund will choose to sell its stocks. This could result in a mutual fund having a losing year but you still hit with a capital gains tax bill because the fund sold some stocks at a gain.
Which Is Best?
Mutual funds may be the best place to start for a novice investor, both because of the relative safety and the low “buy-in” cost. Ultimately, it’s up to you to decide how much control you want to have over your investment decisions. Mutual funds and indexed ETFs put decisions in the hands of others. Stocks (unless you hire a financial adviser) become your responsibility.
For many people, the best solution is a “little bit of everything” approach. With this approach, you would put a portion of your investments in mutual funds or ETFs and a portion in stocks which you actively trade or hold long-term.