What are Stocks, Bonds, Mutual Funds and ETFs?

Estimated read time: 5 minutes

Successful investing generally comes down to the six A's: Asset Allocation, Asset Allocation, Asset Allocation. Research shows the mix of investments, or asset allocation, in your portfolio will greatly determine your overall return.

So, what investments should you have in your portfolio? That depends on several personal factors including your financial goals, when you hope to achieve them, and how much risk you're willing to take to get there. It helps to first have a solid understanding of the basic investment types to determine what's right for you.

What Are Stocks?

One way companies raise capital, perhaps to expand or develop a new product, is to sell shares of itself. These are stocks (also referred to as equities). By owning an individual stock in a company, you essentially have ownership in said company, and, as a shareholder, you can expect to earn a portion of the company's future profits in the form of dividends.

Further, you can benefit from a rise in the stock's value on the stock market, which generally depends on how the company performs and is expected to perform over time, but you can also experience the downside when a company doesn't do so well. Not to mention when a company goes bankrupt and wipes out a stock's value. That helps explain why stock prices tend to fluctuate by large degrees. However, because of the higher risk, stocks have greater return potential than other investments.

The challenge is that individual stocks from well-performing and long-running companies don't come cheap. Nor do they offer as high potential profit margins as, say, a startup. Therefore, investors must first make important choices about which stocks to buy.

What are bonds?

Bonds, meanwhile, are a form of debt. They are issued by local and federal governments, businesses, and other institutions, such as schools and libraries. When you purchase a bond, you are essentially lending money with the expectation of getting your money back with interest.

A bond has a face value and pays a periodic interest payment (coupon) until a specified date (maturity date). The bondholder is given back his or her original principal once the bond matures.

Bonds are also traded on the open market, so their prices can rise and fall, typically not as greatly as stocks. It is rare for bond issuers not to meet their debt obligations. Subsequently, as lower risk investments, bonds have lower return potential.

Still, bonds are attractive for several reasons. For one, they are a consistent source of income. The consistent income provided from bonds are low risk rewards, and, as lower-risk investments, they tend to provide steadier returns. Additionally, bond prices often move independently from stocks, so they can help diversify your portfolio.

What are mutual funds?

An easy way to understand mutual funds is to visualize a shopping cart filled with different individual assets, such as stocks or bonds. Instead of buying each asset in the cart individually, you just buy a share of the cart with other investors.

Mutual funds are the most commonly offered investment in employer-sponsored retirement plans. There are mutual funds that hold only stocks from large U.S. companies, stock from specific geographic regions, bonds from various government entities, and so on.

Every mutual fund is led by a fund manager or team of managers who select which assets to buy or sell. This lets investors avoid having to do the same work themselves. The goal of most managers is to produce higher returns than the market, which makes their funds actively managed. However, the majority of actively managed mutual funds don't beat the market once their fees are factored in. Passively managed index funds, on the other hand, have much lower fees on average and simply try to match market returns.

What are ETFs?

Exchange-traded funds, or ETFs, are similar to mutual funds in that they act as a basket of stocks, bonds or other assets. However, there are some important differences between ETFs and mutual funds.

First, ETFs are traded on the stock market throughout the day just like individual stocks. Unlike most mutual funds, ETFs are not designed to beat a particular market index, but rather match the market's performance minus costs. For example, the Vanguard S&P 500 ETF tracks the S&P 500 index by more or less holding the same stocks in the same proportions.

Because ETFs don't try to beat the market, they require less resources and, therefore, are much cheaper than most mutual funds. A disadvantage of ETFs is that they are more volatile as a result of being traded on the stock market.

How to Decide Which is Right for You

Choosing the right mix of investments, or asset allocation, is one of the most important decisions an investor must make. Each of the asset types we've discussed have their advantages and disadvantages.

Individual stocks and bonds give you the most control over your portfolio. You decide what stocks and bonds to invest in and when. This lets you skip paying management fees and offers the greatest potential returns.

But, with that control comes responsibility. You have to research each individual investment and know when the right time to buy and sell. Further, it is difficult to properly diversify your portfolio with individual investments. Though you don't pay management fees, you do have to pay high face values of each stock or bond.

With a mutual fund or ETF, you don't have to do all guesswork. A fund manager does that. Also, both fund types provide diversification, which helps reduce risk in your portfolio. Between the two, ETFs beat mutual funds on costs. The disadvantage of ETFs is that you give up the chance of returns greater than the market. But most mutual funds are unable to beat the market anyway.

The right choice generally depends on what you want to do with your money. For someone who wants to invest a certain amount of money in hopes of hitting a few home runs, yet doesn't mind taking a loss, then individual stocks and bonds may be the way to go. Most investors, though, are saving and investing for retirement over a long period of time. You don't want to gamble your retirement savings on a few hot stocks. Instead, a combination of stock and bond ETFs makes the most sense. The low cost will make a big difference over time, and the diversification will help provide steadier returns.

Ultimately, what investments are best for you is a personal decision. It is important to choose those that appropriately align with your financial goals and your tolerance for risk. For long-term investors, such as those saving for retirement, diversified mutual funds and ETFs are generally the best option. The risk involved with individual investments makes them best suited for investors who have the time to do a lot of research, or who just want to keep a play fund.