The Differences Between Stocks, Bonds, And Mutual Funds
Investments needn’t instill a sense of confusion when you’re looking to fund your financial goals such as purchasing a home or saving for retirement. Some of the most popular types of investments–mutual funds, stocks, and bonds–offer significant opportunities for maximizing investment, but which one is right for you depends on your portfolio objectives, your preferred timeline, and your risk tolerance.
Here are some easy-to-understand facts that can help you decide where you’d like to stash your cash.
The upshot: If you don’t have the financial expertise or the time to monitor various investments, putting your money into a mutual fund can be a safer and more practical way to invest.
One way to think of mutual funds is to imagine that they’re financial ‘baskets.’ They may hold a single asset type such as domestic large-cap stocks or a combination of investments like a balanced fund that includes stocks and bonds. Mutual funds enable investors to build diversified portfolios at a low cost. Some investors may prefer to build a portfolio with only one stock at a time, while others may opt for a mutual fund that offers more opportunities for diversification.
Mutual funds enable investors to buy a multitude of assets relatively cheaply. For example, instead of purchasing $1,000 in single company shares, you could spend that same amount on a fund that holds that same company and many others. In that regard, mutual funds offer an inexpensive way to diversify your assets and minimize the risk that comes from holding stock in only one company.
Depending on what they’re invested in, some mutual funds are riskier than others. Index funds mimic certain indexes (such as the S&P 500) and tend to be more tax-efficient and less costly when compared to actively managed funds, which sometimes come with sales charges and other expenses.
The upshot: Stocks, either individually or through mutual funds, are best for long-term goals that are five years or more in the future because of the additional risks associated with owning stocks.
Stocks, also known as equities, are often considered the cornerstone of retirement accounts because they tend to boast higher returns than many other investments. A good example: A diversified collection of large stocks such as the S&P 500 Index has averaged about 10 percent a year in returns over the long term.
Stocks represent a wide variety of national and international industries and are available in small-cap, mid-cap, and large-cap sizes. The term ‘cap’ refers to market capitalization, which is computed by multiplying share price by the number of a company’s outstanding shares.
According to Brett Horowitz, a wealth manager at Evensky & Katz/Foldes Financial Wealth Management, “Large-cap stocks tend to be companies that are more established. Small companies tend to have more risk, and the extra risk you’re taking on leads to a higher return.”
The upshot: Bonds are usually best suited to short-term goals or risk-averse investors. Owning bonds or other types of fixed-income securities can help you save for near-term goals like purchasing a car or putting a down payment on a house.
In general, bonds are considered a safer investment than purchasing stocks, but that safety net means you won’t earn the same return that’s possible with stocks. But it’s worth noting that the riskier the bond rating, the higher the interest rate will be and the more you stand to gain (assuming that the borrower doesn’t default). Firms such as Moody’s and Standard & Poor’s determine whether bonds have investment grade status, meaning they carry little to moderate risk, or junk status, which indicates high risk.
Because government bonds are guaranteed by the full faith and credit of the federal government, they’re considered the safest bonds available. They mature in various stages; for example, Treasury bills usually mature in three months, Treasury notes within a year, and Treasury bonds over longer time frames, generally between five and 30 years. Bond interest rates remain relatively low, which means this investment option often doesn’t provide the type of returns most people need to retire in their early 60s.
Local and state governments also issue bonds, and although not all of them are guaranteed, they’re considered fairly safe investments, depending on a government’s creditworthiness. Municipal bonds, on the other hand, offer a distinct advantage as the income generated from them is generally exempt from federal taxes and sometimes state taxes as well.