When you invest in the stock market, it’s always a good idea to diversify your portfolio.
That means spreading out your risk by investing in an array of stocks, bonds, mutual funds, and exchange traded funds in a broad geography that includes the U.S. as well a developed and emerging economies overseas.
But what is the difference between a stock and a fund?
What’s a stock?
When a company goes public through a process called an initial public offering, it issues stock. Stock represents ownership in a company, and the public can buy it by purchasing individual shares, which are units of stock. These shares represent a claim on the company’s earnings and profits.
There are nearly 4,400 listed companies in the U.S. that all issue stock.
Since an individual stock represents ownership of one specific company, when you purchase shares, you’re essentially making a bet on that company. When the company has a great quarter or year with strong revenue and profit, that’s reflected in the stock price, which typically will increase, returning more value to the investors.
By contrast, if that business has a bad year, with reduced revenue and profit, that’s also likely to be reflected in its stock price, which will probably decrease in value.
In short, when you buy an individual stock, you’re placing all of your eggs in one basket.
In short, when you buy an individual stock, you’re placing all of your eggs in one basket. Your fortunes rise and fall with the company. That means your investment is potentially more volatile–it can have big gains or big losses, even in the course of a single day.
What’s a Fund?
Funds are among the most popular investments out there. Investors have poured a staggering $19 trillion into them as of year-end 2016, according to recent industry data.
What they all have in common is that they invest in a basket of stocks simultaneously, in contrast to just one stock. Some funds might even invest in the stock of hundreds of different companies simultaneously. So, instead of investing in a particular technology company, by way of example, you might instead invest in a fund with a technology focus.
The benefit of investing in a fund is that it can potentially help you diversify and spread your investment risk. So, rather than just owning one stock in a particular sector, you could potentially own shares in hundreds of companies in that sector. If one company is having a bad quarter or a bad year, its performance could be balanced out potentially by dozens, or even hundreds, of others that are doing well.
Funds typically invest by themes–they can focus on sectors or industries like clean energy or health care. But they can also invest strategically. For example, they can be aggressive in an attempt to give investors bigger returns, or conservative, in hopes of providing investors income over time. Or they can invest in large, small, or medium-sized companies across different categories, such as growth and value.
Good to know: A mutual fund takes money from individual investors and invests it in a basket of stocks. Something called the net asset value of the fund is determined at the end of each day, and investors buy shares of the fund based on this value.
An ETF is also a basket of funds that sells shares, but investors can trade in and out of it throughout the day, based on the fund’s share price. ETFs also typically invest in companies represented in an index. (Mutual funds can also be index funds.)
You can’t invest directly in an index, which uses a collection of stocks to gauge the performance of the stock market, or a sector of the stock market, over time. Examples of an index are the S&P 500 and the Dow Jones Industrial Average.
You typically buy shares of a stock or fund through a broker-dealer, which specializes in the sale of securities, either in person or through an online account.