Odds are pretty good that investing is not going to be one of the most fun things you do. But it just may help you get closer to the things that are fun, so come along, bring a pineapple cocktail, and learn a thing or two.
One of the first ways that you may invest in the stock market is in funds, mutual funds to be specific.
What is a Mutual Fund?
A mutual fund is bunch of stocks together in a single fund that you can invest in. The fund will be operated by an investment company who will have a fund manager and researchers deciding what to invest in. That means you can buy into the fund without having to do all of the hard leg work of researching all sorts of stocks. (Fun fact: They got their name because they were designed to allow many people to mutually benefit by investing small amounts in a wide variety of stocks to help them diversity.) Since the funds are filled with stocks that change in value during the day, the funds are settled at the end of each trading day. That’s when their share prices are adjusted to reflect what went on during the day in the market. Unlike a stock or ETF (more on that in a minute), you have to wait until the market closes to sell or buy in a mutual fund.
What is an Index Fund?
Index funds are a bunch of stocks together in a single fund that you can invest in. Wait, didn't we just say that about mutual funds? Yep. Index funds are mutual funds. (But not all mutual funds are index funds.) They are built the same, but the way they invest is different. Index funds are structured to match the losses or gains of a particular index. So, if you have a Standard & Poor’s 500 Index fund, that fund would increase or decrease in value by the same amount as the S&P 500 every day. No research needed. These are, in theory, cheaper because they don't have to pay analysts to pick stocks.
What’s the Difference?
Since an index fund is simply a particular kind of mutual fund, they are structurally the same. They differ in their investment philosophy: passive vs. active management of your investments. Fees will likely differ as well, since as we discussed above, one has a team supporting it, the other is just looking at an existing index and matching it. Most mutual funds collect their fee by way of an “expense ratio.” The expense ratio is the percentage of your investment getting paid to the management company every year. Because actively managed funds require a number of highly priced professionals to pick stocks, they tend to cost a lot more — with a typical expense ratio between 0.5% and 1%. Index funds are usually around 0.2%.
So why pick the more expensive option?
Good question. You've likely heard how hard it is to "beat the market" (meaning, make more money over time picking stocks compared to what the broader market achieves), especially when the fund has higher fees. For many people who want a 'set it and forget it' fund, an index fund can be the way to go. But also be mindful that while you're "forgetting it" the market can go up and down. Investors often choose to spread out their money and have a balanced portfolio that may help them not lose so much if the market overall takes a dip. Another reason someone may choose an actively managed fund is that they are looking for certain types of investments, like socially responsible companies that follow certain social, human-rights and environmental criteria (which can mean no guns, cigarettes, etc.)
And Where Do ETFs Fit In?
You may have heard that exchange-traded funds (ETFs) are the passively managed (read:cheaper) alternative to the mutual fund. That's mostly accurate but incomplete. The real difference comes down to the way ETFs are structured: Mutual funds are repriced and traded at the end of the trading day, but ETFs can trade hands throughout the day while markets are open, just like a stock. What does that mean for you? Not much, but it does give flexibility if you need to buy or sell during the active trading day. The majority of ETFs match an index, but there are some actively managed ones, too. Is it all just so clear now??
The bottom line is to invest in what you understand for a fee that you are comfortable paying. If you choose to work with an investment professional, one question you may want to ask is which they recommend for you and (most importantly) why they recommend it.