Freedom Life Planning

The Ultimate Guide to Financial Planning

Understanding Stocks, Bonds, Mutual Funds, and ETFs

 

There are many ways to invest your savings. In this article, we will cover Stocks, Bonds, Mutual Funds, and ETFs. I will also cover how I recommend to use them for investing, and how to apply that to your savings goals. There are advantages and disadvantages to each type of investment. Understanding these differences is very important for reaching your investment goals while minimizing the risk.

Equities vs Bonds

Before we get into the specific categories, it is important to understand the difference between equities and bonds. Equities are ownership stakes in companies and bonds are debt ownership in companies or governments. Equities can have much higher investment returns than bonds but are much riskier and fluctuate more severely. For long term savings goals, we can afford to take the risk of equities as the risk of losing money is much lower over a period of at least 10 years. For short term saving goals of under 5 years, bonds are more favorable as you cannot afford to take as much risk when you will need the money soon. For everything in between, a mix between equity and bonds will provide the best balance between risk and returns.

Bonds

Buying a bond is a type of investment that is buying debt of a country or a company. These are generally safe investments. Government bonds are the safest if buying from a country with a strong financial standing (G8 countries). Corporate bonds have more risk, as a company is more likely to go bankrupt than a country, but they have the potential for greater reward (higher paying interest rates).

My recommendation for bonds is to buy them indirectly through ETFs or low cost mutual funds. This will ensure diversification and provide an easy way to get started.

Bonds are recommended for short term investments and as a portion of medium term investments.

Company Stocks

Buying a stock is a type of investment that is a direct ownership in a corporation. As the company increases in value, your stocks rise. If the company decreases in value, the stock lowers in value. Some companies will distribute a percentage of their profits as dividends to all their stock holders. This can be viewed as your cut in the profits of the company you own.

While stocks can return a lot of profit on your investment, they can also be very risky. If the company of the stock you own encounters difficulty, you can lose a big portion of your savings.

I highly recommend against holding stocks directly unless you have a large investment worth of over $100,000. Even at that point you can often find an ETF that is more secure while still providing you with access to strong investment gains over a long-term period. If you do buy stocks directly, be sure to have significant diversification across different industries. You should aim to own at least 20 stocks across different industries if you are only investing in stocks.

Stocks should represent a small portion of your investments for short-term goals. (Buying a home, car or taking a big vacation).

Stocks, along with other equity holdings can represent a larger portion of your investments for your long-term goals (retirement, college savings for young children).



Mutual Funds

A mutual fund is a type of investment that pools together the investments of many people to buy stocks, bonds, or other investment types. Mutual funds are managed by a fund manager and thus charge a fee for this service. The fee is represented by the MER (Management Expense Ratio) of the fund. Always try to seek out a fund that has a low MER when investing in mutual funds. The MER is deducted from the gains (or losses) of the fund. It is a hidden fee that needs to be avoided as much as possible.

Mutual funds that hold mostly bonds will generally be safer than mutual funds that hold mostly company stocks. However, the Mutual funds holding stocks have a much better chance of making larger gains on the investments.

For people starting to save, I recommend using low cost mutual funds until you have at least $10,000 of investment value. The benefits of switching to stocks or ETFs remain small below this amount. As most mutual funds don’t charge any per transaction fees, it will be easy to add more to your investments each month without incurring any ‘per transaction’ fees.

Exchange Traded Funds (ETF)

An exchange traded fund is similar to a mutual fund but it trades like a stock. Generally, the MER of ETFs are much lower than mutual funds. Most ETFs track stock indices instead of being actively managed like some mutual funds. Most studies show that index investing outperforms or matches actively managed funds in long term returns. Therefore, the gains from being actively managed is outweighed by the MER that mutual funds charge.

For this reason, ETFs are my recommended choice for most of your investments that we will cover on this site. The only exception is for investments that are currently valued below $10,000. This is because the transaction fees will represent too large a portion of the total value of your investments.

There are large selections of ETFs available from Vanguard and Blackrock that will cover a wide range of objectives. Bond index ETFs for short term, Stock Market index ETFs for long term and a mix of the two for medium terms.

Please be sure to check out other articles on this site for more details on specific topics touched on in this one.

For further reading and a great starting point for those learning to invest, while minimizing risk, check out this fantastic classic book: The Intelligent Investor: The Definitive Book on Value Investing.

 

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