Why do so many people never obtain the financial independence that they desire? Often it’s a fear of the unknown. However, the biggest risk you face is not educating yourself about which investments may be able to help you achieve your financial goals.
Knowing some basics – such as the difference between stocks, exchange traded funds (ETFs) and mutual funds – is a start.
Stocks. A stock represents a share of ownership in a business. When you own stock in a company, you actually own a piece of that company. Investors who purchase stock hope to make money in one of two ways – through dividend payments and/or capital appreciation.
The decision to invest in stocks is a personal one that should depend on your individual situation. Before taking this step, and before selecting specific types of stocks to add to your portfolio, there are some issues you should take into account. Over time, stocks will provide you the biggest reward but this reward comes with added risks. To reduce the risk in owning stocks, you should reserve your investment in stocks for long-term goals.
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In addition, you should diversify your portfolio and not simply be concentrated in one stock or one industry. Along this line, it is also difficult to simply pick the one winning stock. To build a more diversified portfolio of securities, an investor can try to buy 10 or 15 different stocks spread across various industries such as finance, technology or energy. Or they can invest via ETFs or mutual funds.
ETFs and mutual funds. While stock is direct ownership in a company, ETFs and mutual funds allow you to buy into an investment which owns the underlying securities. ETFs and mutual funds can buy different investments, but let’s discuss stock oriented ETFs and funds. For example, you can buy a mutual fund which focuses on the entire US stock market with the fund owning more than 3,000 different companies. You never directly own the stocks but you have a pooled investment which gives you access to a more diversified portfolio. If one company is the next Enron, you don’t lose all of your money because it is just a small holding in your overall account.
An ETF is similar to a mutual fund but provides the ability to trade the holding throughout the day. A mutual fund only trades at the close of the investment markets regardless of when you actually placed your trade. While many find this useful, many others do not.
ETFs and mutual funds can be a great way to invest because:
• You can build a more diversified portfolio.
The costs associated with buying and selling the underlying securities are often lower than what you would pay on your own.
• They can be a convenient, cost-effective way to purchase a variety of securities with a relatively low initial investment.
• In many instances, you are getting the services of a fund manager to make decisions about the selection and timing of securities purchases and sales.
However, many mutual funds can have high expenses and sales charges that can have a substantial impact on your return. A fund manager may keep a portion of its assets in low-paying cash alternatives versus being fully invested. Equally as risky, a fund manager’s judgment about certain securities may be incorrect, and a manager may or may not have better results than simply buying an index fund.
While investing can be difficult, understanding the ways to invest should not.
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