Looking to turn a windfall into your first venture in investing? Your first instinct may be to plunk that cash into the hot company stock of the moment, but for most investors the wiser course would be to put that cash into a basket of stocks called an equity fund.
Before you dive in, we'll cover what an equity fund is, why it’s generally a better choice for investors and where you can buy them.
What is an equity fund?
Equity funds are a kind of mutual fund, where thousands of investors purchase shares of the fund, and the fund buys stocks in a range of companies. Often the companies are alike in some way, meaning the fund might buy shares in all the firms listed on the Standard & Poor's 500 index, or it might invest in technology companies.
“Equity” in a company is like the equity that homeowners have in their house; each speaks to a degree of ownership of the asset. Equity funds give investors fractional ownership of companies via the shares they purchased in the fund.
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Mutual funds' popularity among investors continues to rise, and equity funds are by far the most popular type of mutual fund. Of the 55 million American households that invested in mutual funds in 2016, better than 80% had equity funds in their portfolio, according to a study by the Investment Company Institute, an industry group.
How are equity funds different from stocks?
Both individual company stocks and equity funds, also known as stock funds, are ways to own a piece of publicly traded companies, and the attraction of both can be summed up in one word: growth. Buying and holding onto stocks or stock funds over time is a key ingredient in saving for retirement.
Many financial advisors recommend investors have more cash invested in equities early in life, then slowly shift the ingredients in their portfolio mix toward safer investments like bonds and money market accounts as retirement nears.
Why? The growth of individual companies and indexes is a roller coaster ride. The younger the investor, the more time to ride out inevitable market downturns.
Equity funds help smooth the ride. They aren’t immune to market swings. In fact, if the mutual fund is doing its job, its value should mirror the market's moves up or down. But a fund comes with diversification built in: You're spreading your investments across a range of companies or a sector or the whole market. If one company in the fund suffers, stronger performance by others can mask the loss and your portfolio can still go up.
That’s generally a safer journey for your cash than riding the performance of any one company. Direct ownership of company stock carries the potential for market-beating performance, but with greater risk as well.
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Why invest in equity funds?
Equity funds are an easy and economical way to invest in the stock market. There are a couple big reasons why. First, investing in individual stocks requires deep research and a strong appetite for risk. The value of any one company may see more volatile changes compared with an equity fund, whose performance tracks broader market gains and losses.
“If they are going to invest in one company, they need to think of it as play money,” says Celia Brugge, a certified financial planner and principal advisor at Dogwood Financial Planning in Memphis, Tennessee. “You need to ask, ‘Do I have $1,000 to lose?’ Or do you want to use it to start your nest egg?” If it's the latter, she says, an equity fund is the better choice.
“If you are going to invest in one company, you need to think of it as play money.”Celia Brugge, financial planner
Another big reason equity funds are the way to go for most investors: Like all mutual funds, they offer diversification at a discount. The average investor doesn’t have the time or cash to build a broad portfolio one stock or bond at a time. Mutual funds do that for you at a fraction of the cost.
How to invest in equity funds
If you decide equity funds are the right way to go, you'll be confronted with a new concern: Which one? The diversification that equity funds offer means you have plenty of choices, depending on which types of companies the fund invests in.
Equity funds are often built around these themes:
Where the companies are listed: Index equity funds track the companies on a given index, such as the Dow Jones Industrial Average or S&P 500. These help investors reap broad market gains.
What the companies do: A fund that invests in a specific industry, such as insurance, pharmaceuticals, oil and gas, or technology, offers greater diversification than buying stock from a handful of companies in a sector
Company size: Some equity funds focus on the size, or market capitalization, of companies, ranging from large-cap companies such as Apple and Disney to small-cap companies that may not be household names but can produce profitable returns
Location: International or global funds invest in companies and industries around the world, allowing investors to balance declines in one market with growth in another locale
Many investors build a portfolio with a mix of broad market funds and a few industry or geographically specific funds, depending on the individual investor's retirement goals.
And where do you buy them? There are three ways to purchase equity funds:
Through an employer-sponsored retirement account, such as a 401(k) or 403(b). Your choice of funds will depend on the provider your employer chose, but many plans provide a couple dozen or so options.
Directly through a fund provider such as Vanguard or Fidelity Investments, but your choices there also may be limited
By opening a brokerage account. You’ll have more choice if you're not tethered to one fund provider. There can be an initial minimum deposit requirement, but some allow a $0 minimum to invest through an individual retirement account such as a traditional or Roth IRA, or if you set up automatic monthly deposits. Cost and options can widely vary, so shop around.
Wherever you invest, watch the fees, which can erode your returns over time. Also, how the fund is managed matters. Some equity funds are actively managed, which means they try to beat market performance. However, they also carry higher costs. Others are passively managed, meaning they try to mimic the market's performance; they have lower fees and, often, better returns.
In short, Brugge says, rather than chase growth by buying hot individual company stocks, for most investors, “The smarter thing would be to buy the plain vanilla, really boring investment fund."
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» Dive deeper: What is a mutual fund, and how does it work?
» Passive investor? How to build your portfolio with index funds.