New investors who are considering buying stocks often wonder, “Should I invest in stocks? Or something else instead?”
And investors who already know they want to invest in stocks often wonder, “Should I buy my own stocks? Or just buy a mutual fund or ETF and let someone else do the stock picking?”
These are both great questions.
Based on our experience, the best investment choice for you depends on five things:
If you want to invest in stocks (our specialty), we’ll dig into this much more in LEVEL 2 of this course, where we’ll walk you through how to build your own personal stock investing plan based on the five questions above.
But, before we discuss which type of investment is best for you, let’s cover a brief overview of each type, including their pros and cons.
Just a note, most of the pros and cons below are relative to buying stocks. For example, when we say a con of real estate is that it requires more money to invest, we mean as compared to buying stocks.
(NOTE: This is one of 40+ lessons in our FREE course: How to Invest in Stocks: Learn How to Buy Stocks, Make Money, and Avoid Mistakes. We'll bring you from beginner to confident investor fast, helping you make money and avoid mistakes along the way.)
Investing in stocks involves buying shares of ownership in publicly-traded companies.
A mutual fund is a giant portfolio made up of hundreds of stocks (and/or other assets) that are bought and sold by a financial company. Individual investors buy into the mutual fund together and trust the financial company to make smart investing decisions with everyone’s money.
Some mutual funds are actively managed, meaning they trade frequently and the financial managers try to outperform their benchmarks. Other mutual funds are passive, meaning they simply track an index or basic group of stocks over time.
Mutual funds charge an ongoing management fee and some charge additional fees as well.
When it comes to mutual fund investing, the new wisdom is that actively-managed funds often carry high fees and deliver mediocre performance. In general, investors are shifting away from active mutual funds.
Instead, this chart from Morningstar shows that investors have been choosing low-cost ETFs over mutual funds for years now.
Why? Research has shown that many actively managed mutual funds barely beat their benchmarks and charge high fees, resulting in investors who pay a brokerage to lose to a simple benchmark.
ETFs, on the other hand, can track the same benchmarks (and more), often for a much lower fee.
As you can see below, investors have been abandoning the more expensive actively-managed mutual funds in favor of the lower fee index funds, which probably look more like simple ETF index funds.
An Exchange-Traded Fund (ETF) tracks the price of many stocks (or other assets) without actually buying or selling any of the positions (it simply tracks their price as a group).
ETFs can track popular indexes (such as the S&P 500 or Russell 2000), groups of stocks (such as large cap dividend stocks), or entire sectors (such as energy stocks or technology stocks).
ETFs charge an ongoing management fee which is usually lower than actively-managed mutual funds (but sometimes the same as passively managed mutual funds).
When investing in bonds, investors lend money to a corporation or government entity and receive ongoing interest payments in return.
Robo-advisors are companies that use computer algorithms to invest in ETFs based on your personal goals. They use no human intervention to make investment decisions and charge a relatively small ongoing management fee.
Betterment and Wealthfront are well-known examples of robo-advisors.
Investing in real estate involves buying, selling, and renting out physical properties for residential or commercial use.
There are many other types of securities that take some advanced training and experience.
Examples include trading commodities, Forex (foreign exchange currencies), derivatives, short selling, levered funds, futures, options, and more.
Since this course is an introduction in how to invest in stocks, we’ll leave those aside for now.
Now that you understand the basics of each type of investment, let’s dig into which is best by returning to our five big questions on your personal investing situation:
There’s a big difference in strategy between an investor who wants to maximize their returns and an investor who wants to minimize their risk.
In this first question, let’s focus just on the returns portion:
Which type of investment offers the best returns?
To answer this incredibly important question, let’s zoom out. Way out.
Research by Jorda et al looked at the average annual returns for a range of U.S. investments from 1870 - 2015. Keep in mind these figures are real returns, which means the impact of inflation has been removed.
Looking at a wide range of historical data, a few things become clear:
Let’s take another look at stocks vs. bonds using this line graph from Morningstar:
Again, we see that the returns for large cap stocks and small cap stocks soar above the returns for government bonds, treasury bills, and cash.
Stocks have an annual return rate of roughly double government bonds, which turns a one dollar investment in 1926 into $7,353 for large cap stocks and $36,929 for small cap stocks, but only $143 for government bonds.
In fact, in this graphic from Bernstein we see that stocks beat bonds, cash, and inflation over 80% - 85% of 10-year periods from 1926 - 2014:
But, we also see that bonds beat cash and inflation in roughly 70% of 10-year periods from 1926 - 2014.
So, what's the lesson?
Over long time periods, stocks tend to return more than bonds and bonds tend to return more than cash.
If all you care about is maximizing your returns, stocks appear to be the best choice, with real estate a close second.
So why would anyone ever invest in bonds?
Because they involve less short-term risk, which brings us to our next big question.
While bonds have historically returned much less than stocks, they do have two advantages over stocks:
This chart from Fidelity does a good job capturing the balance between risk and returns. It shows the returns and downside risk from 1926 - 2016 for various different portfolio mixes:
On the far left, we see a portfolio called "Short-Term" that's invested completely in short-term treasury bills (basically just cash that keeps pace with inflation so its purchasing power stays constant over time).
From 1926 - 2016, this ultra-conservative portfolio returned an average of 3.38% per year, just enough to keep pace with inflation over time, but not much more.
However, if you look at the worst one-year and worst five-year return, that portfolio has basically never lost value.
So, if you’re an investor who cannot tolerate any downside risk to your portfolio whatsoever, then treasury bills or bonds could be good for you. It’s very unlikely you’ll lose money on them.
But, the downside is you’re leaving a TON of potential wealth on the table.
Now, let’s look at the far right side of the chart. This is their "Most Aggressive" portfolio which is invested 70% in U.S. stocks and 30% in international stocks.
This portfolio has returned an incredible 10.02% per year, on average, from 1926 - 2016. It underscores, yet again, that stocks are some of the best-performing assets for investors.
Great - so what’s the catch?
The worst one-year return for that portfolio was a horrifying -67.6% drop (we’re guessing that was the Great Depression crash of 1929) and the worst five-year return was a -17.4% decline. So again, all that extra upside return comes with some downside risk.
As brutal as those declines are, it’s critical to keep in mind the market has tended to recover (and then some) over 10-year and 15-year periods.
This chart from American Century Investments shows that if you had invested in the S&P 500 during ANY 10-year period from 1926 - 2017, you would've made money during 94% of those samples. And if you had invested during ANY 15-year period, you would've made money 100% of the time.
So, while bond investors definitely look pretty smart during nasty stock market downturns, long-term stock investors have always had the last laugh when it comes to profits, leaving their bond friends in the dust.
If you have a long time horizon to invest in stocks, you can have a decent amount of confidence they should perform well. But if you need your money in the near time (for example, for retirement next year), you could be devastated by a market sell-off and unable to hang tight through a recovery.
The right balance between risk and reward is a highly personal question for investors. Many choose to split the difference by holding some stocks and some bonds and then shifting the mix over time.
Their portfolio might look something like the “Growth” or “Aggressive Growth” portfolios in the Fidelity chart above.
Either way, return and risk are two hugely important factors to consider when deciding which type of investment is best for you.
In addition, investors must ask themselves which type of investment they are most likely to succeed with.
This is another personal question that can make a big difference in what type of investment is best for you.
Some investors are born with all the skills to be great stock market investors. They’re naturally thoughtful, curious, analytical, and enjoy learning about businesses. Others learn these skills over time and perform just as well.
However, some investors are better suited for activities like real estate investing, which might involve traveling around to view different properties, coordinating with repairmen to monitor construction projects, and negotiating with buyers and sellers to turn over their inventory.
Again, this is a highly personal question. Where do you see yourself most likely to succeed?
It’s difficult to provide too much advice here, other than to say this:
Investing in stocks can build tremendous wealth for a wide range of investors interested in a wide range of stocks. However, it does take a certain amount of patience, discipline, analysis, and smart decision making.
It doesn’t have to take up a lot of your time (in our experience, using the right tools and strategy you can earn fantastic profit trading your own stocks by investing as little as 1-2 hours per month).
If that doesn’t feel like a fit for you, or your passion is calling you elsewhere, then you may be better off pursuing other types of investments.
For this question, we’re going to assume you’re interested in investing in stocks because that’s our area of expertise and we can best speak to the time and energy investment involved in different approaches.
First, let’s say you want to do all your own original research and have a small amount of time (call it an average of 2-8 hours per month) to put into your investing activities. In our experience, that’s enough time to hand-research and buy your own stock portfolio.
If you wanted to follow an investment newsletter (where experienced investors send you high-quality stock research and recommendations) you could probably reduce that time to 1-2 hours per month (and likely improve your profits as well).
If you have the time and interest, buying your own stocks could be a good way to get experience investing, have some fun, and most importantly, try to beat the market. This is called “active investing.”
We’ll dedicate an entire future lesson to beating the market (Lesson 13: Can You Really Beat the Market by Buying Your Own Stocks?), but we’ll simply say this for now:
Historically, the S&P 500 has returned somewhere between 7% - 10% per year over long stretches of time.
If you could beat the market and deliver 12%, 15%, or even 20%+ returns each year, you could compound your wealth at an astounding rate.
This is why many investors choose to trade their own stocks: they want to achieve outsize returns that will grow their wealth faster and larger.
But what if you don’t have an average of 2-8 hours each month to trade your own stocks?
In that case, it might make sense for you to buy a few simple ETFs or mutual funds to create a portfolio that matches your return / risk profile and then let them run on their own. This is called “passive investing.”
For most passive investors, the S&P 500 makes an excellent investment. It has a stellar long-term track record, owns 500 high-quality large-cap stocks, and many brokerages offer S&P 500 funds or ETFs for a very low fee.
Some investors choose to put all their investment money into the S&P 500, while others diversify a bit by also buying an international stock fund / ETF, a bond fund / ETF, or an actively managed mutual fund.
When researching mutual funds and ETFs, our one piece of advice would be to look carefully at their after-tax, after-fee net returns.
Research suggests ETFs are better than actively-managed mutual funds at delivering positive net returns (net meaning the percentage return after management fees and taxes are taken out), but each one is different.
Make sure to do your homework.
Robo-advisors could be another good choice for those who prefer a passive investment approach. They manage your portfolio based on your risk profile and implement strategies to minimize your capital gains taxes.
This brings us to another important point:
Do-it-yourself investors who want to manage their own stock portfolio will pay no ongoing management fees to outside parties, whereas do-it-for-me investors who invest through ETFs, mutual funds, and robo-advisors will pay an ongoing fee for the management of their money.
Over time, these annual fees can add up and significantly eat into your long-term investing profits.
Now, if the returns you achieve by outsourcing your investing to an ETF, mutual fund, or robo-advisor are higher than you could achieve on your own, then the fees could be worth it. It’s just important that you ask yourself whether the fees you pay are resulting in higher profits in your account.
The amount you have to invest could rule out a few of your options.
For example, buying real estate properties is likely to require at least tens of thousands of dollars to get started.
And some mutual funds have minimum investment amounts, but this seems to be going away as robo-advisors accept any size investment and steal mutual fund business.
When it comes to stocks and ETFs, you can start with pretty much any amount. While stock prices vary, you can often buy shares for under $10, making them an accessible option for many investors.
We covered a lot in this lesson, breaking down the pros and cons of investing in stocks, bonds, real estate, mutual funds, ETFs, and robo-advisors.
Here’s a quick summary of the important points from the lesson:
Stocks have had excellent returns over time, making them one of the best long-term investments to maximize your profit (real estate is close behind).
In the short term, stocks can have volatile drawdowns, so it’s critical you invest for the long term.
Bonds offer great stability and steady income, but their long-term returns lag stocks by a ton. Buying bonds leaves a ton of potential wealth on the table over time.
Actively managed mutual funds are a dying breed as their high fees tend to erode their often mediocre performance.
Passively managed mutual funds (basically index funds) and ETFs can provide an easy and diversified way to invest in stocks for the passive do-it-for-me investor.
Fees charged by mutual funds, ETFs, and robo-advisors can eat into your long-term returns in a big way.
There are no long-term fees for investing in stocks, except for trading costs which are often less than $8 per trade or free at some brokerages.
Buying dividend stocks can provide steady bond-like returns in the form of dividends with the upside of price gains if the stock goes up.
Stocks, mutual funds, ETFs, and robo-advisors can all decline painfully during crashes, bear markets, or corrections. But over the long term, they have tended to perform very well. Since 1926, there’s never been a 15-year period where the S&P 500 didn’t earn a profit.
Investing in stocks doesn’t have to take up a lot of your time. Using the right tools and strategy you can earn fantastic profit trading your own stocks by investing as little as 1-2 hours per month.
Next up, there are over 8,700 stocks trading in the U.S. Let’s cover how they break down by size, and which size stocks offer the best returns: Lesson 6: Market Cap: An Overview of Small-Cap, Mid-Cap, and Large-Cap Stocks
This lesson is from our free course, “How to Invest in Stocks: Learn How to Buy Stocks, Make Money, and Avoid Mistakes.”
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