What are Stocks and Index Funds, ETFs, Mutual Funds?

What are Stocks and Index Funds, ETFs, Mutual Funds?

Stocks, or shares, always have a strange vibe around them if you talk about them. People don’t understand them. They might joke a bit about it and then leave. Even when stocks and index funds are such powerful tools to become financially free.

What are Stocks and Shares?

Stocks are simply ownership certificates of a company. It’s simple. Let’s say that you start a company yourself. If you are the only owner, you own 100% of the shares in that company. Now let’s assume you start the same company with a business partner. You can decide to split the shares in your company 50/50, maybe 25/75, or any other combination really.

The stocks of public companies are split into millions of little units or shares. That means that you can buy a very small piece of that company, by buying one share.

If you have your own company, you are fully responsible for all profit and losses made by the company. If you do well, you can extract a lot of cash out of the company in the form of dividends. The same principle applies if you own shares in a publicly traded company. You are entitled to the profit and loss of the small percentage of the company you actually own.

Why Should I Care?

Why you should care? Because stocks will make you rich! Stocks have the power to make you rich beyond your wildest dreams! Now for most people, this would not work. They don’t have the guts to invest in something as volatile as stocks. But for you, my friend, it will be a major change in your life.

Dividends

You probably buy stocks to generate wealth. Investing in stocks helps you build wealth in two different ways.

The first is what I mentioned before. You are entitled to the profit your company makes. Some companies decide to pay out (parts of) their profits to shareholders. Usually, they do this every quarter. That means that every quarter you receive some cold, hard cash, just because you own shares in a company.

Value Increases

Now the other reason has to do with your shares increasing in value. You can imagine that if companies are expected to be profitable in the future, you might want to own their shares. Because if they turn out to be profitable, you will receive some of that profit.

If a lot of people want to own shares, the price of the share will go up. This is economics 101, with high demand prices increase. The price of stocks is determined by the market. The market are all the players buying and selling together.

You could put in a buy order for 10 shares in FakeBusiness Co. for 100 euros. As soon as somebody decides to sell 10 shares for this price, there is a deal. It works for sell orders too. People put in orders to buy and sell, and as you can imagine buyers want low prices and sellers want high prices.

The price where the two meet is called the spot price, or the actual, current price of the share.

Which Stock do I Invest in?

Now we know how investing in stocks can generate wealth through dividends and increasing share prices, how do you pick a company to invest in?

It’s simple. You don’t pick a stock to invest in. Let me repeat that tot be perfectly clear:

You don’t pick a stock to invest in. Period.

B

You simply invest in all stocks you can buy! That’s my strategy and it’s called indexing. The problem with investing in a single stock is that you take on a lot of risks. Yes, the company can be extremely profitable and make you rich, but it can also go bankrupt and leave you with nothing.

You mitigate these risks by investing in more than a single company. You want to hedge your bets and diversify. This is most easily done by investing in a stock market index. That way, you don’t have to pick some individual stocks yourself, you simply buy all of them.

Investing through stock market indexes, is my strategy. Also, my friends over at The Poor Swiss just published an article on picking the right index fund.

What’s an Index Fund?

So what exactly is an index fund? An index fund is basically a large pool of cash, invested in a lot of different stocks. The stocks they invest in are not chosen randomly, they are part of an index.

A stock market index is a way of measuring the performance of a group of stocks. The most well-known one might be the S&P 500, an index measuring the performance of the largest 500 US companies.

In Europe, we have the DAX 30 in Germany, the AEX 25 in The Netherlands, and the CAC 40 in France, and in almost-not-Europe-anymore-UK you have the FTSE 100.

Say I want to invest in all 500 companies in the S&P 500, I could buy them myself, or I buy shares in an index fund tracking this index. That’s a lot easier for me and probably cheaper. Now it’s someone else’s job to buy and sell those shares instead of mine.

There are two general ways you can invest in index funds. The ones that are mostly used in Europe are called ETFs or exchange-traded funds, and the ones more popular in the US are called mutual funds.

ETFs or Mutual Funds?

The differences between ETFs and mutual funds are slim. Both are index funds, both are cheap ways to diversify, and for your long-term wealth-building it doesn’t really matter which one you pick.

An ETF is a product that you can trade on the stock market. It is basically a share in the pool of money that is an index fund. By its very design, the value of an ETF follows the value of the underlying index. You can buy and sell ETFs any time the markets are open, just like you can trade stocks.

Mutual funds are a little different, they literally are large pools of money used to collectively invest. An investment in a mutual fund usually is done daily. Also, the pricing of the fund is done daily. That means there is no spot price, but for the long-term investor this shouldn’t matter.

Another difference with ETFs is that you can buy a partial share in a mutual fund. With ETFs, you buy a number of shares, with mutual funds you put in a certain amount of money, which might give you 1.6776515 shares in the fund.

Which one you choose doesn’t matter much. As long as you pick a fund that is broadly diversified, cheap, and easily tradeable you’re good to go!

If you want to see how easy it is to setup an index portfolio, just look at my investments here!

How do you invest in stocks?

Share This With Your Friends!

4 thoughts on “What are Stocks and Index Funds, ETFs, Mutual Funds?”

  1. I personally aim to adhere to the core-satellite strategy, i.e., focus on buy-and-hold ETFs, but have a small selection of individual stocks trying to “outperform” the market because it’s fun. Do note that I say “aim” as my individual stocks still hold too much weight (41%) compared to my ETFs (59%).

Leave a comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.