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Index Funds vs Mutual Funds vs Stocks

Let’s cover the basics, the difference between index funds vs mutual funds vs stocks. Most of us already know or know about trading stocks. These can be purchased individually on a brokerage platform such as ETrade. I think I still have an ETrade account open from a decade ago, which is about the last time I traded on there.

Mutual funds own a little percentage of a large selection of individual stocks. My stock portfolio on ETrade might have 3 individual stocks (Walmart, Southwest Airlines, Trojan Condoms) but a mutual fund or an index fund might have hundreds of individual stocks.

A mutual fund such as Putnam Capital Spectrum will hold a percentage of about 50 different stocks. The fund manager is responsible for picking and choosing the right funds to add or drop in order to achieve the “vision” or “goal” for that mutual fund.

 

Mutual Funds

Mutual fund ticker symbols are 5 letters in length. They can be traded similar to but not exactly like stocks.

Mutual funds are therefore a portfolio of actively managed funds. Just like when you log onto ETrade and pick and choose what you want to buy and sell based on your menstrual cycle, there is a balding dude sitting behind a computer who selects the right mix of stocks to hold in that particular mutual fund.

There is a fee for this potential brilliance, for the time this active manager invests picking and choosing the right funds. Each mutual fund has its own fee structure, most of which is transparent, some of which is hidden.

I clicked on the Expenses tab for that Putnam fund I mentioned above and I got a page full of percentages and have no clue exactly which fee I would be charged. The fees ranged from 0.7%-1.7% and there might be a sales charge as well.

Active traders take a lot of shit ever since index funds came on the scene – yet active traders still exist. Not all mutual funds are as bad as they are made out to be. Some active traders can generate some profits in very niche markets and some can’t – and if you know which ones can then guess what, you’ll be rich.

 

Stocks

Stock symbols are 2-4 letters in length.

Stocks are easy, you type in a symbol and buy however much of that stock you want. Let’s say you want to buy Walmart, WMT. You buy it on your brokerage account and there are no fees you’ll pay for buying or holding that stock.

There is a lot more transparency because you only have to pay a trading fee which can range from $5-$20 and you can buy as little or as much of that particular stock.

You can then choose how long you will hold that stock and when you’ll sell it or how much of it you’ll sell. You can even short the stock by betting against it. You don’t get to do that with a mutual fund – the balding dude takes care of the buying and selling.

You can create a portfolio similar to a mutual fund by buying all the funds listed in the mutual fund of your choice but you’d need a lot of money to buy enough of each to offset the trading fees. Then you’d have to know when to buy and sell.

 

Index Funds

Index funds also have ticker symbols, usually 5 letters in length. These can be bought and sold like stocks but again, not exactly like stocks. If you want to do that, however, there are ETF’s – topic for another day – these can be traded just like stocks.

An index fund is a type of mutual fund – the passive kind. It follows an index or a market sector. Because there is no balding dude buying and selling funds in and out of the fund, the fees for index funds are much lower.

An example of a market sector (or index) would be the S&P500 index which many are familiar with. There are a bunch of different indexes, each designed by some nerdy company to track a certain group of funds.

One of the index funds I hold, VTSAX, follows an index called the Wilshire 5000. This index lists every-single-damn stock traded in the US. It’s called the Total US Equities Index Fund for that reason.

By investing in the VTSAX, I own a little bit of every single stock traded in US.

When I clicked on the expense ratio tab for one of these funds, a single number popped up – 0.04% – very different from the 25 different numbers that popped up when clicking on the Putnam Mutual Fund. To me that displays transparency which I appreciate.

 

Index funds vs Mutual Funds vs Stocks

So which of this wins?

There is no winner. It depends on what kind of return you are after and what your risk tolerance is.

It also matters how well you understand each of these investments. Though it’s said that you should 100% understand whatever you are invested in, that’s bullshit. Nobody, no-body, understands how the stock market works – I’ll bet my cat’s life on it.

For what it’s worth, those with the highest net worths and the highest incomes and the highest education the US were polled to have the highest percentage of investments in index funds vs mutual funds vs stocks.

 

In Summary

So you can buy an actively managed mutual fund, a passive index fund, or you can buy and sell your own individual stocks. It’s up to you whether you believe an active manager can do better than yourself or better than a particular index.

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