I want to invest my money in either stocks or mutual funds. What’s the difference?

The first thing that someone like yourself should know before you invest your money is what you want your money to do.  What is mean by this is are you looking to make a quick buck or are you thinking about the long haul?  This choice will determine the types of investments you will find attractive.

There  is a plethora of different investment instruments that are available for someone who’s looking to invest.  This can be advantageous but daunting to the investing newcomer.  What’s an ETF?  What are financial derivatives?  What are blue chip stocks?  These might be some questions that a novice investor may have when looking at different avenues of investment.  Often, financial jargon tends to get in the way of understanding the various forms of investment.

Stocks are a type of security that designates ownership in a publicly traded company.  By owning a share of a company’s stock, you have a claim to their assets and earnings.  In essence, you become an owner of a company.  By purchasing common stock, you have a right to vote at shareholders’ meeting and are entitled to receive a dividend, which is a portion of a company’s profits paid out to its owners.  By purchasing preferred stock, you do not have the right to vote at shareholders’ meetings but can still receive a dividend.  The reason why this type of stock is classified as ‘preferred’ is that in the event of liquidation (when a company goes out of business). Preferred stockholders have priority over common stockholders in the company’s assets and earnings.  That is to say, the residual assets and earnings are divvied amongst preferred stockholders first and then to common stockholders.  In the event of liquidation, common stockholders may not get their investment back!  This, however, does not mean that common stock is a poor choice of investment.  Thanks to the United States’ accounting system, the financial information of publicly traded companies must be publicly reported so that anyone can see it.

In the same vein, mutual funds are a collection of various financial instruments managed by a mutual fund company such as Vanguard and T. Rowe Price.  A mutual fund pools money from its investors and invests that lump sum of money in various securities.  This basket of securities can include stocks but is not limited to them.  A mutual fund can be comprised of bonds, money market securities, other mutual funds and commodities, to name a few.  A mutual fund manager will then invest that money in accordance to what type of mutual fund it is.  One that focuses on long term financial stability will buy and sell securities that are not very risky.  Relatively small risk investments offer relatively low returns but will continue in the foreseeable future.  Higher risk investments offer higher returns, but there is a chance that the company offering that security will not perform well.  This is called the risk-return tradeoff.  Higher risk investments must offer a higher return because there is a high level of uncertainty of success and life of a company in the future—which translates to a higher risk of you not getting your money back.  With mutual funds, you’ll also have to be aware of the various fees and commissions that you’ll have to pay.

The type of investing that you want to do depends on how risk averse you are.  If you like taking risks, you’ll probably want to invest in stocks or mutual funds that offer the potential for higher than the market average returns. If you do not like taking risks but want to see constant returns on your investment, you’ll probably want to invest in blue chip stocks or large cap mutual funds.  Blue chip stocks are the stocks of companies like General Electric—companies that are well established and very stable.  Large cap mutual funds are like blue chip stocks in that they are comprised of large corporations that are well established and financially stable.

Apart from the basic mechanics of these types of investments, one  thing you must know is what you want to do with your money and what you want your money to do for you. Make sure you ask yourself the following questions before you do any investments:

Do you want to invest your money?  If so, which to do you prefer—high returns and high risk or low returns and low risk?

Written by Eric Pinter, Peer Educator, Financial Wellness Program, University of Illinois Extension