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by Mike Rowan www.Erollover.com 2008
Mutual Funds vs. ETFs, Stocks, and Bonds
There are many different kinds of investments that you can purchase inside of your 401k, IRA, or other retirement accounts. However, the most common type of investment for your 401k or IRA plan is the Mutual Fund. Before you begin buying mutual funds, it's helpful to understand how they compare to other popular types of investments, such as ETFs, stocks, and bonds.
ETFs
Exchange-traded funds (ETFs) are the security type that is most
similar to mutual funds. First created in the early 1990s, ETFs are
index funds that trade like stocks. They offer the broad
diversification of mutual funds with the instant liquidity of
stocks: ETFs can be bought and sold throughout the trading day,
unlike mutual funds. In addition, they often have low expense
ratios, some of which are even lower than those of traditional
index funds.
Why Buy Mutual Funds Instead of ETFs?
There are several considerations to take into account when deciding
between mutual funds and ETFs:
Cost: Transaction costs, also
known as commissions, are fees investors pay every time they buy or
sell a security. Though you can buy no-load mutual funds for free
from most fund companies, you'll pay a
commission each time you buy or sell an ETF. If
you'd like to buy your investments gradually, in
stages, without paying commissions each time, mutual funds are
likely a better choice than ETFs.
Selection: Though ETF
offerings are multiplying quickly, in some areas they
don't yet rival the selection offered by the
thousands of mutual funds on the market. If
you're looking for a specific type of
investment, your only choice may be a mutual fund.
Flexibility: Like index funds,
ETFs track the performance of a fixed selection of securities. As
such, they lack the flexibility to respond to changes in the
marketplace that affect the value of the particular securities they
hold. Actively-managed mutual funds may be your best choice if you
prefer to own investments that can adapt constantly as markets
change. On the other hand, large mutual funds are often unable to
effectively shift their holdings in response to changing market
conditions. Mutual funds also sometimes have minimum holding
periods, which penalize you for selling your fund shares until a
certain amount of time has passed, ranging from six months to
several years.
Individual Stocks
Though mutual funds make it very convenient and easy to own
hundreds of individual stocks with just one investment, they
require you to give up control of the specific stocks you own.
There are two reasons why surrendering control of the individual
stocks you own might lower your returns:
Capital gains taxes:
You'll incur capital gains tax liabilities just
from holding a mutual fund, even if you later sell the fund at a
loss. The amount of capital gains tax liability you incur is up to
your fund manager, not
you, because he or she decides how much stock to
sell and how often to sell it.
Bad picks: Some mutual funds
place a sizeable portion of their holdings in just a few stocks. If
one of those stocks plummets in value, the fund will also.
Conversely, if one of the fund's stocks shoots
up in value, you won't have the freedom to sell
it. In addition, since stocks don't charge
investors expense ratios, you pay only the transaction costs
required to buy and sell. That means if a stock increases in value
by 10%, you'll actually receive a 10% return on
your investment, minus whatever commission costs
you've incurred and taxes you owe on your
profit.
Why Buy Stock Funds Instead of Individual
Stocks?
There are several reasons why you may want to own stock funds
instead of stocks:
Diversification: A portfolio
of several stock mutual funds, each of which holds a basket of many
different stocks, is more diversified than a portfolio that
contains only a few individual stocks. More diversification means
less risk.
Volatility: Volatility refers
to the amount that an investment's value tends
to fluctuate investment's value. Generally,
individual stocks are much more volatile than mutual funds. If
volatility makes you uneasy, mutual funds are a better choice than
stocks.
Cost: With certain exceptions,
you can usually buy mutual funds without incurring any transaction
costs. Each time you buy or sell a stock, you'll
pay commissions.
Convenience: Mutual funds make
it easy to build a balanced portfolio of investments with minimal
time or effort. To build a balanced portfolio of individual stocks,
you'd need to spend hours researching each stock
before you buy and then monitoring your holdings on at least a
weekly basis thereafter.
Individual Bonds
Individual bonds are a compelling investment for investors looking
for a steady stream of income: you buy a bond with a certain
interest rate and maturity, or duration, and you then receive that
interest for the life of the bond. If you buy $1,000 of a bond with
a 5% interest rate and a maturity of 10 years,
you'll receive $50 per year for ten years. The
price of the bond can fluctuate until its date of maturity, but if
you hold the bond until it matures, you'll
receive your original principal back in full. If you sell the bond
before it matures, you may receive more or less than the price you
originally paid and your interest payments will cease.
Why Buy Bond Funds Instead of Individual
Bonds?
There are two main reasons to own bond funds instead of individual
bonds:
Diversification: Since bond
funds usually hold many different bonds of a given type, you can
diversify instantly by buying just a few funds, each of which
specializes in a different type of bond.
Convenience: By buying one
bond fund, such as the Fidelity Total Bond Market Fund,
you can get instant access to a broad assortment of bonds in just
one investment, complete with a yield roughly equal to the average
yield of all the bonds in the fund. Using a bond fund is not only
more convenient, but also less time consuming and expensive, than
buying a portfolio of individual bonds.
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