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Index Funds vs. ETFs vs. Stocks: Which One is Better and Who to Invest With.

Image source: Dreamstime

Index funds, exchange-traded funds (ETFs) and stocks are 3 basic investment building blocks that can add significant value to your investment portfolio. In this article, we present them in a very clear manner to simplify investing. We outline some very interesting differences and similarities between them. We tell you which one we think makes the most sense for the newbie investor. We then conclude with a few robust investment brokers we believe offer the newbie investor the most value and a brighter path to financial freedom. These investment vehicles are much easier to understand than you may realize. Read on.

Stocks: a simple definition

  • Stocks: In basic terms, stocks (video) give you an opportunity to own a piece of a company. When you buy a company's stock, you become a shareholder. They are traded (i.e. bought and sold) actively on a stock exchange (e.g. New York Stock Exchange, American Stock Exchange, etc.). Because investors buy and sell stocks constantly throughout the day, their prices change a lot. To give you a better idea of the fluctuations in a stock's price, let's consider Apple's stock (AAPL) by using this link from MarketWatch. During an active trading session, keep refreshing this link to see how the stock price changes from one second or minute to another. Index funds are very different from stocks.

​Index funds: a simple definition

  • Index funds: an index fund (video) is a special type of mutual fund that tracks the returns of a broader market index (e.g. the S&P 500, NASDAQ, etc.). As a mutual fund, an index fund is composed of a basket of stocks or securities. An index fund doesn't try to beat an index, in terms of returns; it seeks to match or give the exact same returns as the index. Huh? Don't worry. Let's make this more plain by comparing two S&P 500 index funds: FXAIX (Fidelity 500 Index Fund) and VFINX (Vanguard 500 index funds) against the index itself. We show this comparison in the graph below.
Data Source: MarketWatch. Graph 1. YTD Comparison of the Vanguard 500 Index Fund (VFINX) and the Fidelity 500 Index Fund (FXAIX) to the S&P 500 Index. Green line = FXAIX; Black line = VFINX; Blue line = SXP (S&P 500 index). Data current as of 4/16/19.

As you can see in Graph 1 above, both index funds have yielded similar returns to those of the S&P 500 index. As of April 16, 2019, the YTD returns of both index funds (VFINX and FXAIX) sit at a comfortable 16.00%. Each time the S&P 500 index goes through peaks (gains) and valleys (losses), you can expect both index funds to follow a similar trading pattern. The small 0.04% difference between the index funds and the S&P 500 index is due to the fact that FXAIX is composed of 508 stocks and VFINX has 516 stocks as of 4/16/19. The S&P 500 has exactly 500 stocks, the 500 largest U.S. stocks. Exchange-traded funds are as easy to understand.

 ​Exchange-traded funds (ETFs): a simple definition

  • Exchange-traded funds: an exchange-traded fund or ETF (video) is a type of fund that has benefits similar to stocks and index funds. Like stocks, ETFs are traded actively on a stock exchange. As a result, their prices change constantly, as investors buy and sell corresponding shares. Like index funds, ETFs are composed of a basket of stocks or other investments. ETFs typically have very low expense ratios. There are many different types of ETFs. An ETF may also track an index. We show this below by comparing the Vanguard S&P 500 ETF (VOO) to the S&P 500 index.
Data Source: MarketWatch. Graph 2. YTD Comparison of the Vanguard 500 ETF (VOO) to the S&P 500 Index. Blue line = VOO; Black line = SXP (S&P 500 index).

As shown above, both the ETF (VOO) and the S&P 500 index have yielded similar returns as of 4/17/19 (~15.70%). Here are a few important learning points you should take home.

Stocks, index funds, ETFs: benefits and risks

  • You can make or lose money from stocks, index funds and ETFs. Stock market investments are not FIDC-insured. Check out how investors make money from stocks and mutual funds.
  • ETFs have benefits similar to index (mutual) funds and stocks. 
  • Both stocks and ETFs are bought and sold on a stock exchange. 
  • Both index funds and ETFs are composed of a basket of stocks. As a result, they both offer incredible diversification, making them relatively safer investments than stocks.
  • Both index funds and ETFs are bought at their net asset value (NAV). The NAV is the amount of money you need to buy one share of the index fund or ETF.
  • The price of ETFs, like stocks, change constantly throughout the day. You can sell an ETF or stock and buy it back seconds or minutes later. This simple fact may be beneficial to an investor. If an ETF or stock is trading at a very high price, you can immediately sell your shares and make a profit. Likewise, if the stock or ETF's price is falling, you can decide to sell it to prevent further losses.
  • Unlike ETFs and stocks, index funds do not trade throughout the day. An index fund is redeemed at the end of the day at the new NAV after the markets close. This presents advantages and disadvantages for the index fund investor. If the stocks that comprise the index fund are trading high, you cannot immediately sell shares of the index fund and make a profit. Also, if those same stocks are trading low, you cannot immediately buy shares of the index fund at the low price or sell them to stop your losses. 
Stocks and ETFs charge brokerage fees. Index funds don't. Photo source: Dreamstime

Stocks, index funds, ETFs: fees & commissions

  • Both index funds and ETFs can have very low expense ratios. Generally, ETFs have lower expense ratios. The expense ratio is the amount of money you pay in expenses to manage the fund. If you buy an index fund or ETF with an expense ratio of 0.05%, it means you can expect to pay $5 for every $10,000 you invest in that fund.
  • You pay a commission or brokerage fee each time you buy or sell shares of a stock or ETF. Index funds don't have such fees. These fees, along with expense ratio fees, can severely diminish your returns over time.
  • Index funds allow you to buy partial or fractional shares; ETFs and stocks don't. For example, if an ETF or index fund is trading at a share price of $3.50 and you have $20.00 to invest, you will be able to buy 5.714 fractional shares of the index fund (20.00/3.50 = 5.7140). Conversely, you can only buy 5 shares of the ETF (3.5x5 = 17.5), leaving you with $2.50 in un-invested cash.
  • Stocks, index funds, ETFs: Which one should you buy?

    Stocks, index funds, ETFs offer investors an incredible opportunity to save for retirement and build wealth. Choosing between one over the other is a personal decision. Each individual is advised to consider his/her tolerance for risk, investing experience, length of time and amount of money to invest, among other things. If you are very good at picking high-quality and winning stocks, stock investments may be appropriate for you. If you are newbie investor with a small amount of money and plan on making periodic small investments, index fund investing may be more appropriate; you won't have to fret over brokerage fees. Plus, legendary investor Warren Buffett loves index funds! If you are looking for a very low-cost way to invest, ETF investing may be a solid choice. Once you decide which investment type makes the most sense for your needs, it is important to choose a quality investment broker. 

    Stocks, index funds, ETFs: Who should you invest with?

    The last few fears have seen the emergence of numerous investment brokers and robo-advisors. Their main goal is to simplify and make investing easy for the individual who wouldn't otherwise invest. However, all investment brokers and robo-advisors are not created equal. When we put this blog together, our mission was simple: convince individuals that investing does not have to be complex or require a lot of money. To help fulfill this goal, we sought out brokers that we thought could provide added value to this website and our visitors. Parameters and features we considered include investing simplicity, low fees, user interface, ease and speed of account creation, and investments quality. Here are a few investment brokers and robo-advisors we think can provide value to any new investor.

    1. Wealthsimple. This robo-advisor will help you diversify your investing portfolio across the entire market, using low cost ETFs. They even show you how much your money can grow with their simple-to-use investment simulation calculator. Start investing with Wealthsimple today.
    2. The Motley Fool. Stock picking is hard! If you want to invest in stocks and become an expert at picking winning stocks, The Motley Fool is the way to go. Sign up with the The Motley Fool.
    3. Acorns. This robo-advisor allows individuals to become investors with the simple use of an app. Check out these Acorns reviews or invest with Acorns.

    The bottom line

    Very few things are as powerful as knowledge. You don't have to be an expert to become an investor and start building a better financial future for you and your family. You just have to be willing to learn the fundamentals. Stocks, index funds, and ETFs investing can add tremendously flavor to your investment portfolio, if you use the right robo-advisor. Wealthsimple, Swell Investing, and Acorns are a few robo-advisors that can help brighten your financial future. 

    Like this article? Please share and leave us your feedback in the comment section to help us improve and grow. Subscribe below to get our latest articles. Here are a few more articles you may find useful: I buy the U.S. economy with a single index fund. The initial result is stunning! | How to make money in real estate without buying physical properties | How to use your tax refund | Cash is trash, not king. Invest it | How to buy and invest in marijuana stocks.

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