Stocks, Mutual Funds, or ETFs?

Investors face a dizzying array of investment options. There are two broad categories of investment from which investors may choose.

Fixed-income investments like certificates of deposit (CDs) and corporate or government bonds are appropriate for those who may need some income, but can afford minimal risk to their principal. As investors get closer to retirement or enter retirement, the fixed income category becomes much more important.

But today, I want to talk about that second category: equities. Equities are ownership shares in a company. The most common type of equities are individual stocks, as well as mutual funds and exchange traded funds (ETFs).

Today I want to review these categories. Even seasoned investors could occasionally use a refresher course in the basics.

Individual Stocks

I only recommend an individual stock for a small portion of your portfolio. Individual stocks can be a good addition to an already diversified portfolio.

In my view, it is unwise to put more than 2%-3% of your investment funds in a single stock. While there is some debate about the total number of stocks required for adequate diversification, most experts recommend 20, 30, or even more individual stocks for the equity portion of your portfolio.

If you follow that rule, you can understand why it isn’t a good idea to have more than 2%-3% in a single company. If you have 30 stocks in your portfolio, with 3% in each company, then that covers 90% of your portfolio. And if you put more than 3% in some companies, you will have to back down the percentage on others, which defeats the purpose of diversification.

Mutual Funds

A solution to the diversification issue is to invest in a stock mutual fund. Mutual funds pool the money from a number of investors and spread it across many stocks. With a single investment you can achieve significant portfolio diversification.

As an example, consider the Vanguard Wellington Fund (VQNPX). It invests primarily in large, U.S. companies. It is diversified across sectors and across individual companies. For example, although it does have a few holdings above the 3% level I discussed earlier, the Top 10 holdings only represent 22.7% of the fund’s assets.

As of 06/30/2019, the fund held a total of 1,217 individual stocks. That’s the kind of diversification beyond the reach of most investors. But a disadvantage of such extreme diversification is that it becomes difficult to beat the market, because you essentially own the market.

Of course there are plenty of different options within the mutual fund universe that can give you the amount of diversification you desire. You can even invest in a sector-specific mutual fund if you believe your portfolio needs more exposure to a specific sector (or a certain geographic region), or if you expect a certain sector to outperform the overall market.

Exchange Traded Funds

Exchange traded funds (ETFs) share many similarities with mutual funds. Using another example from Vanguard, consider the Vanguard Growth ETF (VUG). It holds 280 individual stocks. The Top 10 make up 40.4% of the fund, so there is significantly less diversification within the largest holdings.

But there are couple of big differences. One is that ETFs trade on an exchange like stocks. That means that unlike mutual funds, in which the value is simply determined according to the value of its holdings, sometimes the value of the ETF can develop a disconnect with the value of its holdings. With an out-of-favor sector, that means that you can potentially buy the ETF at a discount relative to the underlying assets.

In a large, diversified ETF like VUG, that premium or discount is generally quite small. For example, year-to-date, VUG has averaged a 0.01% discount to its underlying assets. But for smaller, sector or country-specific ETFs, these discounts can sometimes exceed 10%.

If you can buy an ETF at a substantial discount, you are getting the underlying assets for less than their market value. That discount will disappear when the sector comes back into favor, which will potentially boost your returns.

The other major difference from a mutual fund is that ETFs typically try to track a specific market index. They are generally more passively managed and therefore have lower fees and expense ratios.

But it doesn’t have to be all or nothing. Most investors can benefit from owning more than one equity category. Select individual stocks can complement a portfolio that contains mutual funds or ETFs. In fact, while individual stocks can be risky, that risk can be managed by keeping individual stock positions to a small percentage of your overall portfolio.

If you’re looking for the right balance between risk and profit, turn to my colleague Jim Fink, chief investment strategist of Options For Income.

Jim is a seasoned investor who has devised a trading system that made him rich. Now, he wants to share his secrets. Jim can show you a fast, easy trade that pays off in a big way, every Thursday. It’s sort of like getting an extra paycheck.

Jim can point to scores of satisfied readers who made big money following his advice…and he can show you how to follow in their footsteps.

Want to learn more? Click here for our presentation.