- Some checking accounts earn interest. However, this interest is typically not worth considering and generally shouldn't be used as an investment vehicle
- FDIC insured up to $250k (ie, even if the bank goes bankrupt, the government will make sure you get your money). Risk free
- Similar to a checking account, but generally with higher interest rates
- By federal regulation, you can only make six withdrawals per statement cycle. Otherwise, you are charged a fee (and if you keep doing this, your bank may close your account)
- At least at the moment, the interest rates are low and can't really be considered an investment vehicle (though it is a great place for your emergency fund)
- FDIC insured up to $250k
CD - Certificate of Deposit
- You deposit money at a bank for a fixed length of time, determined at the time of the deposit
- CD interest rates are generally higher than that of savings accounts
- The longer the term of the CD, the higher the interest rate (but also, the greater risk that interest rates will rise during the lifetime of the CD, incurring an opportunity cost)
-CDs can be broken (as in, you get a refund before the term is up) for a penalty (typically several months worth of interest)
- Again, right now, interest rates are low enough that they're generally not worth considering as an investment vehicle
- FDIC insured up to $250k
- When you own a stock you own a piece of a company
- The return of a stock comes from two sources: the value of the stock itself, and any dividends the stock may return. The dividend yield of the US stock market index was ~2-3% in the past couple of years
- In order to buy stocks, you must go through a broker, who finds a seller of the stock you're trying to buy (and vice versa)
- Stock prices fluctuate throughout the day
- Typically the broker will charge a fee when you buy or sell a stock
- Typically you cannot buy fractional shares
- Stocks, and mutual funds and ETFs that invest in stocks, have the highest risk of all vehicles listed here (but also the highest return, on average)
- There is a bid ask spread. You will always end up buying a stock at a little bit higher than the true value (the Net Asset Value, or NAV), and you will always end up selling a stock at a little bit lower than the NAV
- When infrequently traded, the returns from stocks are taxed at a lower rate than wage income.
- You loan an institution, such as the US government, money and they pay you back later, with interest
- US Treasury bonds are considered essentially risk free
- Bonds are also issued by states, cities, and corporations. These have higher risk (particularly those issued by corporations)
- Despite the above, they have a much lower risk than stocks, but a lower average return
- As far as I am aware, there are no purchase fees associated with individual bonds.
- A mutual fund collects money from its investors. A management team (or it could just be an individual) invests that money in stocks, bonds, etc. as they see fit (but they are obligated by law to tell you what they are investing in). The ones that I will discuss are those that invest in stocks, bonds, and the money market (short term CDs and bonds, and I believe a couple other things)
- Priced once a day, after the stock market closes
- You can hold fractional shares of a mutual fund
- One interesting side effect of mutual funds being priced once per day is that you don't actually know how many shares of the mutual fund you are buying. This isn't a big deal though
- Some mutual funds charge a purchase fee. Some others charge a redemption fee. And some even charge both! Avoid these
- For mutual funds that invest in stocks, similar rules on the tax advantages of investing in stocks vs wage income apply
ETF - Exchange traded fund
- A relatively new investment vehicle
- Typically have some management team like a mutual fund that decides how to invest their clients' money
- Traded like stocks
- Again, for mutual funds that invest in stocks, there are tax advantages of investing in ETFs vs wage income
Why use mutual funds instead of ETFs?
The number one reason is automation. A typical mutual fund company can automate your investments by withdrawing money from your bank account on a recurring schedule.
On the other hand, I have never seen a brokerage offer automated investing into ETFs. Part of the issue is the inability to buy fractional shares - you can't just hand them $500 and expect they invest all of it. They could feasibly place a market order with your money, and keep the leftover money in cash, but market orders are generally a bad idea anyway because of flash crashes.
In general, ETFs are actually more tax efficient than mutual funds, because you can expect them to distribute less capital gains than the mutual fund version, if at all. But, in the case of Vanguard funds and ETFs, there is an exception (as explained on the Bogleheads wiki):
Vanguard ETFs are structured as another share class of a mutual fund, like Admiral or Investor shares. This is a process unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:
- Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF.
- Conversion: mutual fund shares can be converted to ETF shares without a taxable event. This helps when transferring assets to another broker, including charitable donations. Conversion in the other direction is not possible.
The second point is an argument to start with mutual fund shares at Vanguard, if unsure. One can always convert to ETF later if needed.
The tax efficiency advantage is a patented advantage you will only find at Vanguard. Combine that with point #2, and the only advantage of starting out with the ETF version is that the ETF version typically has a lower expense ratio than the Investor share class of the the mutual fund version. However, once you reach the balance threshold for admiral shares (typically $10k), your mutual fund shares qualify to be converted to admiral shares, so the cost difference in absolute terms is not that high. Also, as I discussed earlier, there is the bid-ask spread that has to be paid with the ETF.
So long as the US government stays solvent. If the US government can't stay solvent, we've got other more pressing problems. ↩︎