Should You Invest in Stocks, ETFs or Mutual Funds?

Should You Invest in Stocks, ETFs or Mutual Funds?

New investors may think that certain investment products, such as mutual funds or exchange-traded funds (ETFs), are just steppingstones on the way to the big boys of investing, stocks.

That couldn’t be further from the truth.

Most investors use a portfolio of mutual funds to diversify, and then keep that portfolio — rebalancing as needed — straight to and through retirement, with investing in stocks never entering the picture. The Investment Company Institute estimates that 90 million individual investors owned mutual funds in 2014. Meanwhile, data from the Federal Reserve show that less than 14% of families invest in individual stocks.

So, which investments are best for you?

If you want to be completely hands-off

If you want to invest but want to do the least amount of work possible, then you’re probably going to want either a target-date mutual fund or a relationship with a robo-advisor.

Mutual funds pool investor money and buy a range of investments, like stocks or bonds. These funds tend to be actively managed by a professional who picks and chooses the investments within them.

A target-date fund is a type of mutual fund that invests in other funds to create a diverse mix of stocks, bonds and other investments. It automatically rebalances and becomes more conservative as it approaches a specific date, generally the year when its investors plan to retire. So if you’re 25, you might buy a 2055 target-date fund; over the years, that fund will slowly start to take less risk.

Target-date funds instantly diversify you, which means all of your money should be in that fund — otherwise, you risk losing some of that diversification.

“Find one that fits your time horizon, with an allocation that fits your goals. If you add other investments, you could be counterbalancing something that the fund itself is doing,” says David Hunter, a certified financial planner with Horizons Wealth Management in North Carolina.

Robo-advisors are online portfolio management services that invest for their clients and automatically rebalance portfolios as needed. Two of the leaders in this field are Betterment and Wealthfront (here’s our comparison of the two). These companies generally invest in ETFs (more about these next).

One downside of target-date funds and robo-advisors is that they can be more expensive than a DIY approach.

Target-date funds have expense ratios with an asset-weighted average of 0.57%, according to the Investment Company Institute. The expense ratio simply reflects the cost of an investment, so 0.57% means investors pay $5.70 for every $1,000 invested. Robo-advisor management fees tend to range from 0.15% to 0.89%, in addition to the cost of the investments themselves.

If you want to minimize fees

If those expense levels worry you and you don’t mind putting together your own portfolio, index funds and exchange-traded funds will look pretty good to you. Both replicate a stock market index: For example, the Vanguard S&P 500 ETF invests in the stocks in the S&P 500.

There are also bond index funds, which can be used to balance out the risk in your portfolio.

Because these funds passively follow the performance of an overall index — rather than being actively managed by a professional, as mutual funds are — they tend to have lower costs. According to the Investment Company Institute, the asset-weighted average expense ratio for index funds that invest in equities is only 0.11%.

The main difference between index funds and ETFs is that ETFs are bought and sold like a stock. That means ETF investors may pay a commission, which can eat into returns much like an expense ratio would. However, several online brokerages — including the ones NerdWallet selected as best for ETF investors — have lengthy lists of commission-free ETFs.

If you want to be hands-on

Could you do much of the work of a mutual fund, index fund or ETF yourself, by buying stocks outright? Sure, if you want to quit your job and start day trading.

Jokes aside, that would be an ambitious undertaking, and stock trading carries more risk than the typical investor is willing to take on, particularly when it comes to retirement money.

But if you want to try buying stocks, the best compromise is setting aside a small portion of your funds for active trading, while investing the rest in a diversified portfolio of index funds or ETFs.

To get started, you’ll need a solid base of investing knowledge and an understanding of the research required to thoroughly vet a stock before buying it.

The bottom line

Two of the most important rules of investing are to diversify your portfolio and minimize expenses. A lack of diversification can bring on unnecessary risk, and expenses eat into your investment returns, making a big impact over time.

Low-cost index funds and ETFs help accomplish both goals, and are the best choice for most retirement investors. Those who want a little outside help can also work with a robo-advisor.

More from NerdWallet:

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: Twitter: @arioshea.

Image via iStock.

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