There are a lot of investment products available and a lot are difficult to understand, for the consumer with little investment knowledge. Three common products, mutual funds, exchange traded funds and equities are similar, but function very differently in a portfolio.
TUTORIAL: Investing 101: Portfolios And Diversification
Other than stocks, taking a close second in any investment popularity contest is the mutual fund. Anybody with a company or government sponsored retirement portfolio has most of their money invested in these funds. Mutual funds may be popular, but they're not well understood.
Think of a mutual fund as a collection; the collection could be stocks, bonds or nearly any product. Any fund that is actively managed has a team of managers and advisors, who attempt to beat the overall performance of the market. For the person who has little or no investment experience, mutual funds offer a professionally managed product that should make money for you, without having to monitor a complicated portfolio.
The problem with mutual funds is that after fees, a majority of stock funds underperform the stock market and this isn't new. Back to the 1960s, stock mutual fund performance has lagged the market by an average of 2%. Although many stock funds underperform the market, passively managed index funds have lower costs and closely track the performance of the market. (For additional reading, check out: Is Your Mutual Fund Safe?)
Exchange Traded Funds (ETFs)
Similar to mutual funds, exchange traded funds are often a basket of stocks, bonds or other investment products, but unlike mutual funds, ETFs are traded on the stock exchanges. More importantly, ETFs don't try to beat the market like stock mutual funds, but instead reflect the performance of an index, sector or other product. The SPDR S&P 500 is an ETF that tracks the performance of the S&P 500 index. (To know more about SPDR ETFs, read: What Are SPDR ETFs?)
ETFs continue to increase in popularity, due to their lower costs and their nature to reflect the market, instead of attempting to beat it.
ETFs have a higher degree of volatility, because they are traded like stocks.
Equities, the formal term for stocks, represent a small piece of limited ownership in a company. Shareholders are said to have limited liability rights, because an equity holder is not liable, should the company be sued. For investors who are looking for a product that has no fees, an equity is one of the few choices. Although there will be a commission to buy and sell an equity, as well as any fees paid to a financial advisor, equities are still one of the least expensive investment options.
As many have learned, along with being a low-cost product, equities are also highly volatile. On any trading day, individual equities could rise or fall by 50%, or more. Along with volatility, it also takes a lot of knowledge and experience to pick stocks that will rise in value. Stocks are appropriate for nearly every portfolio, but paying for the help of a financial advisor is the best choice for investors with little experience.
The Bottom Line
A diversified portfolio may have each of these options, but for younger investors looking for aggressive growth, mututal funds or ETFs that follow the performance of certain stocks, may be the best option. For those who are getting close to retirement, bond mutual funds or bond ETFs should be highly weighted.