Buying Stocks 101

For the novice investor, picking individual stocks and bonds can seem like an overwhelming endeavor.  Most people shudder at the thought of putting so many eggs into once basket, and rightly so.  Fortunately for them, the market has invented several vehicles which shelter the investor from the risks of buying stocks individually, and also provide a measure of professional management to a stock portfolio which would be difficult for an individual to achieve alone.  Collectively, these investment vehicles are called funds, and they come in several types to address specific investor needs.  We will explore some of them below.

Mutual Funds

The first type of fund we will discuss are Mutual Funds.  These are by far the most common type of fund traded these days, and they form the bulk of most people’s 401Ks.  A mutual fund is essentially a collection of securities purchased with a pool of investor money, with those securities chosen because of some strategy for growth defined by the fund manager.  So what benefit does a mutual fund provide as opposed to buying stocks individually, you might ask.  Simply, they spread the risk around.  Instead of buying one hot stock in the tech sector, you might hold a fund which itself holds scores of positions in various tech companies.  You also get the benefit of a professional fund manager, who undoubtadly is able to react to news affecting those stocks much quicker that you yourself can.  While you may not have the dramatic growth of a rocketing IPO, you also tend to avoid the crashes that come more often.  The mutual fund investor is usually looking to do two things: simplify and diversify.

ETFs (Exchange-Traded Funds)

Exchange-Traded Funds, or ETFs as they are commonly called, are a special type of fund created to mirror the major market indexes, such as the S&P 500 for the Dow Jones Industrial Index.  The idea here is that these funds would hold the same stocks as are in their corresponding index, making it easy to keep up with broad movements in the market and offering diversity over larger sectors of the market.  Some differences between ETFs and Mutual Funds are that there isn’t a minimum investment as there is with a mutual fund.  Also, you will always pay a commission on an exchange-traded fund, whereas you will only pay a commission on a mutual fund if it carries a “load”.  Another key difference is that while you cannot buy and sell options in a mutual fund, you can in an ETF.  For more on options, look here.  An ETF has several attractive features that some investors love such as lower capital gains taxes, generally low fees, and the ability to buy and sell them throughout the day.

Hedge Funds

A lot of media attention has been given to Hedge Funds lately, primarily due to their role in the financial crisis, but still many investors aren’t sure what they are or why one might invest in them.  A Hedge Fund is essentially a private partnership that operates with very little regulation from the SEC (which you can bet will be changing in the near future) which invests in a large number of varying assets applying unique and varied investment strategies in order to hedge against risk and in doing so increase the return to levels above normal investments, such as mutual funds.  To break it down further, Hedge Fund managers try to reduce risk and increase return by leveraging low risk investments against high return investments, or vice versa.  Generally, Hedge Funds require a long-term investment, maybe two years or more.  And they use aggressive investments strategies in order to reduce risk and increase return, which itself is risky.  They are an option for the investor looking to beat average markets return rates, but they should not be considered with without much research and vetting.

REITs (Real Estate Investment Trusts)

REITs are a little bit different.  We’re not buying stocks here.  In fact, they aren’t even technically a fund.  Real Estate Investment Trusts, or REITs, are actually corporations that hold properties or real estate related assets.  A REIT could hold hotels, shopping malls, office buildings, undeveloped land, or even commercial mortgages.    REITs are obligated to distribute 90% of the income from property holding to shareholders in the form of dividends on an annual basis.  The main advantages of REITs are that they invest in revenue-generating properties or paper instead of corporations making them and ideal option for those looking for an alternative to the stock market, and that they diversify an individual’s investment over a large number of properties thereby blunting some of the risk of real estate holdings.

If you are looking for something other than simply buying stocks or holding cash in a C.D., one of these funds may be just what you need.