OK, I admit I struggle a little with my electronic gadgets. Trying to sync my laptop with my handheld, tablet, and desktop, and then making sure my wireless printer works on all of the devices is not my idea of a good time. In fact, it is downright frustrating. But somehow, I manage.
Just when my technologies are running smoothly, I am forced to upgrade the software on one of the gadgets, and the process starts all over. It makes me want to scream. Instead, I log in and have a “chat” with some online help desk, which starts with my request that the specialist explain the steps to me as if I’m a third grader.
People tend to use a lot of jargon when trying to explain their area of expertise. While familiar to them, it can be confusing and frustrating to folks like you and me. For that reason, I try to keep things as simple as I can when talking to clients.
It is time we clear up some of the lingo that is being tossed about these days by Wall Street. Having clarity on these concepts and investments can go a long way toward making smart portfolio decisions that last a lifetime.
Let’s start with some basics: What is the difference between an index fund and a mutual fund?
An index fund is a type of mutual fund that owns all of the companies that make up a particular index, such as the S&P 500. This is in contrast to a more commonly used idea of a mutual fund, which is actively managed by either an individual fund manager or committee that attempts to outperform a particular benchmark, like the S&P 500 index, through the selection of “top-performing” companies.
Although most professional stock pickers underperform the market over time, Wall Street and its legion of stockbrokers want you to think that the secret to reaching your financial goals is through their ability to beat the market. For smart investors, a far simpler and more sophisticated approach to investing in the stock market is to capture the market’s entire return over time through an index fund and leave it at that.
Moving on: What is the difference between an ETF (exchange-traded fund) and a mutual fund?
ETFs, introduced in 1993, are built much like mutual funds in that they are a basket of assets, but with one significant difference: Mutual funds are bought and sold at the closing price each trading day, while ETFs can be traded throughout the day in the same manner as individual stocks.
Are ETFs better or worse than mutual funds? As long as you incorporate ETFs in your portfolio in the same manner as a long-term investor buys and holds a traditional mutual fund, you can reap the benefits of an ETF’s low cost and tax-efficient structure. But because of the ease in which ETFs can be traded throughout the day, many investors now buy and sell ETFs with the same rapidity as individual stocks. The performance numbers of the professional stock pickers remind us how that strategy is likely to turn out.
In light of Wall Street’s dismal track record at beating the market with individual stocks, the financial services industry is revising its marketing strategy (again). Wall Street now claims to provide value to clients’ portfolios, not through the active selection of stocks, but through the active selection of a new breed of ETFs that represent specific industries and countries, all in an attempt to beat the market once again. Same outcome, different story.
When contemplating Wall Street’s latest gimmick, remember that reaching your financial goals should be dependent on the decisions you make in your everyday life, i.e. your saving rate, not on someone’s ability to “beat the market.”
Let this be your driving force in building a successful portfolio.