Investing to fund a secure retirement should be one of your top financial priorities, and successful investing requires appropriate asset allocation. This means putting the right amount of money, based on your age, into safe investments like bonds -- and also higher risk investments like stocks.
The stock market has, over time, consistently provided investors with higher returns than "safer" investments like certificates of deposits and bonds -- but there are also risks because buying stocks means acquiring an ownership interest in companies. If you buy stock in a company that performs poorly, your investment could decline in value or even become worthless if the business goes bankrupt.
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Skilled investors can examine a company's financial situation to determine the worth of a share using a process called a fundamental analysis. But, understanding the different factors impacting a company's viability is complicated enough, much less trying to project whether its business model will lead to rising share prices. Many people who try to "play the market" by investing in stocks they believe will be successful end up underperforming the market or even losing a lot of money.
If you're not 100% sure how to pick stocks, you're usually better off not trying to buy shares of individual companies. But, since your appropriate asset allocation involves buying at least some stocks, you'll need to find another way to invest in the market. Fortunately, you have options, like mutual funds and ETFs.
Mutual funds are created when many investors -- including individuals and institutions -- pool money together into one big pot of cash. The combined pot of money is used to acquire stocks or other assets. Each investor in the fund owns a very small amount of the many different assets the fund invests in.
Some mutual funds are managed by fund managers who decide what investments to make. Fund managers are usually paid handsomely which means mutual funds often come with high fees. There are managers who are worth the salaries they earn because their funds consistently outperform the market as a whole. Most fund managers, however, aren't great at picking stocks and their funds underperform.
Other mutual funds are index funds, which means fund managers don't pick individual assets to buy. Instead, an index fund consists of shares of all stocks on a particular index. When you buy an index fund, you own very small shares of all of the stocks on the index your fund is tracking. For example, an index fund that tracks the Dow Jones Industrial Average would invest in shares of the 30 companies that make up the DJIA. Index funds are both cheaper than actively managed mutual funds and largely outperfrom them.
There are many different indexes, including indexes tracking the S&P 500, the Nasdaq, global financial markets, blue chip companies, and small-share companies. The goal of index funds is to replicate either the performance of the entire market or the performance of the sub-sector of the market the fund is tracking. Index funds buy and hold stocks and there's no need for a well-paid fund manager, so operation fees and investment costs are lower.
Mutual funds aren't traded like stocks, but instead are priced based on the net asset value (NAV). When you buy a mutual fund, you buy your shares at the end of the day, with NAV setting the price. Many mutual funds, including index funds, have high minimum investments. You may need thousands of dollars to buy in, which puts funds out of reach of beginning investors. However, there are options for mutual funds if you don't have a fortune to invest. Vanguard's Target Retirement Funds, for example, require only a $1,000 minimum deposit, have very low expense ratios, and distribute your money into other Vanguard funds based on the date you expect to retire.
Exchange traded funds
Exchange traded funds are also pooled money used to buy assets, like stocks or bonds. However, ETFs are traded on stock exchanges, like the New York Stock Exchange or the Nasdaq. ETFs can be purchased at any time during a trading day and don't have the minimum investment requirements of mutual funds. You can buy as little as a single share of an ETF.
ETFs can also track indexes or invest in different types of assets, just as mutual funds do. Buying a selection of ETFs makes asset allocation easy by facilitating investments in various asset classes that respond differently to prevailing economic conditions. To create a well-balanced portfolio, you could invest in four ETFs: the Vanguard S&P 500 ETF (NYSEMKT:VOO), which tracks the U.S. market; the Schwab U.S. Aggregate Bond ETF (NYSEMKT:SCHZ) which gives you exposure to bonds; the Vanguard FTSE All-World ex-US ETF (NYSEMKT:VEU) to invest in foreign markets and the Vanguard REIT ETF (NYSEMKT:VNQ) to invest in Real Estate Investment Trusts.
Both mutual funds and exchange-traded funds make it possible for you to own many stocks -- along with other assets -- without ever having to learn the ins-and-outs of stock selection and without taking risks associated with buying individual stocks. Diversification can be made easy with the right portfolio of ETFs or mutual funds, so there's no reason not to have the right investments-- even if picking stocks isn't something you're interested in doing.
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