My goal in this post is to get everyone (or at least Yunji and my mom) acquainted with the most common financial terms, acronyms, investment vehicles (ways to invest), and asset classes (grouping of investments that exhibit similar characteristics). Additionally, I’ll talk about risk, expected returns, and diversification. Lastly, a quick disclaimer: I am not a financial advisor and the following is for educational (and hopefully some entertainment 😉) purposes only.
[Skip to Indexes and Index Funds]
A quick recap on why we aren’t sitting on cash…
In a word: inflation.
Inflation makes our money worth less tomorrow than today. If we sat on cash, our purchasing power would degrade over time and so would our quality of life. There’s no issue with having some cash, but having the bulk or a large portion of your net worth tied up in cash long term will pose a problem.
…or buying CDs
Okay, so cash isn’t going to work. How about going to your bank and getting a CD (certificate of deposit). While this was a fine solution in the 90s (and probably earlier–I don’t know I wasn’t alive), current rates (~0.55%) just won’t cut it. If we assume inflation in the US is ~2%, we would be giving the bank our money to lose about 1.5% per year–that isn’t great math. Additionally, we would be tying up our money and reducing our liquidity (the ease with which an asset or security can be converted into ready cash without affecting its market price) in addition to losing to inflation.
Stocks vs Bonds
Okay, intristang, you’re not painting a very rosy picture here (yes, I can talk to myself digitally). So, how can we beat inflation (~2%)–and potentially get returns to cover future expenses–with as little risk as possible?
Quick aside, while sitting on cash or getting a CD from the bank seem risk-free, I’d argue you have inflation risk with both and liquidity risk from a CD.
The two main asset classes I’ll be talking about are: equity (stocks) and debt/fixed income (bonds).
Why stocks or bonds? Well, if inflation was 0% or negative or if CDs were closer to historical returns, we could probably get away with cash or almost-risk-free CDs. However, we’ve gotta play the hand we’re dealt. Because of current inflation and CD rates, the “best” options we have are stocks and bonds.
A quick recap on stocks and bonds:
Stocks/equity: represent ownership in a company
Debt/bonds/fixed income: represent lending money to someone/entity/government
With stocks, you will incur more risk but have a higher expected return, while with bonds you will incur less risk but have a lower expected return. The expected return is the profit or loss that an investor anticipates on an investment that has known historical rates of return.
An oft-quoted fact is that the S&P 500 historically averages about 8-10% per year (sans inflation). Because we have been tracking the S&P 500 among other indexes, stocks, etc. over time, we can make broad assumptions around expected returns per asset class.
Indexes and Index Funds
What is the S&P 500? The S&P 500 is one of the US’s major indexes which tracks the 500 largest companies listed on stock exchanges in the US. That’s all an index is: a broad benchmark that is tracking the sum of smaller components.
The major indexes tracked in the US are the S&P 500, Dow Jones Industrial Average (30 “prominent” companies listed on US exchanges), Nasdaq Composite (almost all stocks listed on the Nasdaq; think technology), and the Russell 2000 (small-cap stock market index of the smallest 2,000 stocks in the Russell 3000). If you look abroad, you might see Germany’s DAX or Japan’s Nikkei 225. These are similar in that they measure the top X companies listed on a country’s exchanges.
Okay, great, so an index is just a benchmark of how well a country or country’s largest companies or sector is performing. What is an index fund then?
Index funds are funds that represent a segment of the market, such as the S&P 500 or the Russel 2000. It is a passive form of investing that sets rules by which stocks are included, then tracks the stocks without trying to beat them. Index funds can be invested in via ETFs or Mutual Funds.
tl;dr: an index is a broad benchmark based on smaller components; an index fund is a way to passively invest in an index
What is an ETF?
An ETF stands for exchange-traded fund (honestly you don’t need to know that). Think of an ETF as a basket of investments. Instead of owning a share of a single company an ETF gives you broader exposure to multiple companies or assets, which in turn reduces your risk and increases your diversification.
There are ETFs that attempt to mirror the S&P 500 (SPY or VOO) and those that give exposure to a sector like technology (XLK or VGT) or financials (XLF or VFH). Some other common ETFs include VTI (total US stock market) and BND or AGG (total US bond market). Another few ETFs to know might include QQQ (Nasdaq top 100 stocks) or MSCI (emerging markets). Those abbreviations are tickers and what are used to look up current price/performance and/or to search when you want to buy or sell.
tl;dr: ETF = basket of investments; could mirror an index, a sector, country’s stocks, or group of countries’ stocks
What is the difference between an ETF and a Mutual Fund?
Okay, so now we have a broad understanding of an index, an index fund, and an ETF. What, then, is the difference between an ETF and a mutual fund?
How they’re managed
Mutual funds are professionally (and typically more actively) managed portfolios of stocks and/or bonds. When I say actively managed, I mean by the professional and NOT by you/the investor. Think of an old guy in a suit trying to beat the market–he/she is actively buying and selling stocks in individual companies to try and outperform the market for their fund. You’re paying for that guy’s suit, salary, and probably coffee. Remember: paying, costs, and fees are almost always bad.
On the other hand, ETFs are typically passive and have rules set to follow indices or whatever theoretical segment they are aiming to mirror. While ETFs are typically passive, they can be actively managed. On the other hand, a mutual fund can also be more passive as well.
While actively managed funds may outperform more passive funds in the near term, over the long term it is harder to consistently beat the mark AND fees compound over time.
tl;dr: how active a fund is translate to fees/expens ratio; fees are bad
Fees
An expense ratio is how much an investor pays each year as a percentage of what they invested. Vanguard’s total US stock market ETF, VTI, carries a 0.03% expense ratio. This translates to an investor paying Vanguard $0.30 for every $1,000 they invest. Alternatively, some actively managed mutual funds charge 1% or $10 for every $1,000. $10 might not seem like much, but over time it will eat away at your gains–and you want your gains. Because mutual funds are typically more actively managed you are paying a fee for that management.
tl;dr: higher expense ratio = higher fees; fees = bad
How they’re traded
ETFs are traded just like stocks throughout the day. What $VTI cost at 11:54 am might be different than what it costs at 12:08 pm. Some investors like this because they feel more active or in control of the trade. On the other hand, mutual funds only trade once: at the end of the day. While you the investor can only trade a mutual fund once per day, the fund manager can buy and sell stocks within that fund throughout the day that may affect the fund’s price/value.
This is the smallest and most negligible difference IMO. The only annoying part about the nature of how mutual funds trade is having to wait to see their price update at the end of the day.
tl;dr: ETFs trade like stocks; mutual funds trade once at the end of the day
Automation
This, IMO, is where mutual funds shine. You can set up automatic investments and withdrawals into and out of mutual funds based on your preferences. This is how your 401k probably works as X% is taken from your paycheck and immediately invested into Y$ of mutual fund Z.
Another thing to note is when you buy a mutual fund you are buying X$ of the mutual fund whereas when you buy an ETF you are buying X shares. This results in needing to do a little math when buying ETFs. Instead of buying $1,000 of VTI you would buy 10 shares (assuming VTI was trading at $1000/share–spoiler alert: it currently isn’t).
Taxes
Because mutual funds are more actively managed and involved a professional manager attempting to beat the market, they are buying and selling more frequently causing more taxable events. ETFs are typically much more tax-efficient due to their passive nature. If you are holding mutual funds in tax-advantaged accounts, this won’t affect you; however, if you’re holding mutual funds in taxable accounts, then this (in addition to higher fees/expense ratios) will eat at your gains.
Minimum investment
You can buy a single share of an ETF (assuming you have the money to cover the single share). On the other hand, many mutual funds have a minimum investment. For Vanguard, the minimum for most mutual funds is $3,000.
Final thoughts on ETFs vs Mutual Funds
As a broad generalization, I would lean toward ETFs over mutual funds almost all of the time due to fees and taxes alone. Mutual funds can and do make more sense in tax-advantaged accounts like 401ks and IRAs/Roth IRAs.
Let’s examine a quick case study before we close out:
Vanguard offers their total US stock market fund as an ETF $VTI and a mutual fund $VTSAX. As of writing a single share of $VTI would cost $222.12 whereas you would need $3,000 to invest in $VTSAX at all. $VTI’s expense ratio is 0.03% whereas $VTSAX’s is 0.04%. We can either look at this as their expense ratios being basically the same OR $VTSAX being 33% higher than $VTI. Buying $VTI you will have to do some math to understand how many shares you want to buy vs how much money you have available to invest whereas with $VTSAX as long as you have >$3,000, you can simply choose a dollar amount to allocate. Lastly, you can buy $VTI throughout the day and have a little more control over the trade whereas with $VTSAX your order will close at the end of the day. Based on the above differences, hopefully, you have an idea of which investment vehicle is more suitable for you.
What is a TDF?
I have intentionally not covered retirement accounts (and will have a retirement-focussed post coming soon), but I did want to briefly touch on TDFs.
A TDF is a target-date fund. In theory these sound awesome: choose a fund custom-tailored to when you want to retire. The massive advantage of a TDF is simplicity.
The downside is that that simplicity comes at a cost. TDFs typically have different mixes of equity and debt (stocks vs bonds) and within those allocations have varying degrees of international vs domestic breakdowns. Sound complicated? These complications lead to–you guessed it–higher expenses and fees. Additionally, these varying mixes of debt, equity, and international exposure trying to beat the market seldom come out on top. You don’t have to take my word for it: look at your current 401k options and check the 10-year performance of some available TDFs versus more broad funds like the total stock market or S&P 500 and you will typically find TDFs have higher expense ratios and poorer performance.
tl;dr: TDFs seem simple but the underlying assets tend to be more complicated than owning a total stock market and/or total bond market fund; TDF fees are typically higher and performance is poorer
Final Thoughts
I originally intended to cover investing in real estate, commodities (e.g.: gold), alternatives (e.g.: wine, collectibles, art, etc.), and topical investments like crypto, SPACs, and NFTs, but I will cover those in a standalone post next week. I will also cover average returns per asset class and talk more about diversification.
Hopefully the above was helpful and/or intristang, but if you take away one thing: increase the amount you can save each month and find an investment that suits you. Find a way to automate (or semi-automate) that investment and then find ways to increase how much you can save and thereby invest each month.
Did I forget anything? Is there anything you’d like me to clarify or go into more depth? Please let me know in the comments 🙂
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