Turning a novice investor loose with an Internet investment account is like leaving a kid alone in a candy store.

Everything looks good and promises such wonderful rewards, but overindulging — especially in the wrong confection — can bring with it a world class upset stomach.

To begin, understand all investments have their inherent perks and pitfalls.

Some may promise richer profits. Others come with less risk. That’s why understanding how these investments function is such a vital step in crafting the best retirement plan possible.

Most investments can be categorized as stocks, bonds and mutual funds.

Stocks

Also called equities, stocks are like sports cars: They’re fast, they’re sexy, and they appeal to buyers that like a little vroom.

Indeed, few other asset classes can match the hidden potential of publicly held stocks. They’ve been the cornerstone to most retirement accounts because they’ve boasted higher returns than many other investments, clipping along at an average 10.4 percent a year between 1925 and 2006, according to Ibbotson Associates.

Stocks come in all shapes and sizes — for every industry imaginable, U.S.-based and overseas alike, and are usually categorized as large-cap, mid-cap and small-cap. The term “cap” is short for “market capitalization,” which is computed by multiplying share price by the number of a company’s outstanding shares.

“Large-cap stocks tend to be companies that are more established,” says Brett Horowitz, a certified financial planner at Evensky & Katz. “Small companies tend to have more risk, and the extra risk you’re taking on leads to higher returns.”

According to Ibbotson Associates, small caps have grown by an average 12.7 percent annually over the past seven decades. The annual 2 percentage point lead over large caps compensated investors for the extra risk they’d assumed.

Promises and pitfalls

A well-timed investment in computer giant Apple, for example, could easily have set you up for an early retirement. Its stock price languished in the mid-teens in the early 2000s, and in the ensuing five years shot up nearly twentyfold.

With that opportunity for rocket-powered growth, however, also comes greater risk.

Consider the wide-eyed optimists who bet all their savings on a high tech start-up in 1999, only to see their paper wealth — plus some — evaporate the following year when the dot-com bubble burst.

To maintain a balanced portfolio, Shashin Shah, a Certified Financial Planner and Chartered Financial Analyst in Dallas, suggests average investors have no more than 10 percent of their total portfolio allocated to individual stocks with 80 percent in stock funds and the remaining 10 percent in bond funds.

Perils of employer stock

Bear in mind, of course, that company stocks do not present excessive risk to your portfolio unless you are overexposed to a particular sector — or company.

That goes double for those who invest in the stock of their own employer.

Through stock options, employee stock purchase plans and company stock selections in their 401(k)s, many investors hold a disproportionate percentage of their company’s stock in their total asset portfolio, leaving them vulnerable.

Should their employer falter, not only is their financial security at stake, but they’re likely to lose their job at the same time.

It was a lesson learned by thousands of employees of energy trader Enron Corp. More than 60 percent of Enron’s 401(k) retirement funds were invested in the company’s stock.

Thousands of its employees lost their jobs and life savings when Enron shares plunged from more than $80 a share to less than $1 before it filed for bankruptcy in 2001.

If your retirement plan is currently overexposed to your employer’s stock, consider diversifying through your personal investment accounts by adding money to other investments outside of your 401(k) — in your individual investments, IRAs, etc.

Bonds

When you buy a bond, you’re essentially becoming a lender, since bonds are really nothing more than an I.O.U. that’s been issued by a government or corporation.

In general, bonds are considered safer investments than stocks. But that’s not always true. Bonds are “rated” and the lower the rating the better interest they pay and the riskier they are. Firms such as Standard & Poor’s and Moody’s are among agencies that determine if bonds are “junk” status, meaning they carry high risk, or “investment grade,” meaning they carry little to moderate risk.

U.S. government bonds are guaranteed by Uncle Sam, so they’re the safest around. They mature — or come due — in various time periods. Treasury bills generally mature in three months while Treasury notes typically mature within a year. Treasury bonds mature usually between five and 30 years. Historically, long-term government bonds have returned an average of 5.4 percent annually, according to Ibbotson Associates.

Local and state governments also issue bonds. Not all are guaranteed, but they’re considered relatively safe investments, depending on a government’s creditworthiness. Municipal bonds have a distinct advantage: Income is generally exempt from federal taxes and sometimes free from state taxes, too.

Mutual funds

Think of these as baskets that may contain bonds, stocks and cash equivalents. With thousands to choose from, mutual funds come in a variety of styles. They may hold a single type of asset, such as only domestic large-cap stocks, or a blend of investments, such as a balanced fund with a mix of stocks and bonds.

Mutual funds also come in a variety of styles. Some are riskier than others. Index funds are geared to mimic certain indices (such as the Standard & Poor’s 500) and they tend to be more tax-efficient and less costly than, say, managed funds that may also have sales charges and other expenses.

Mutual funds enable investors to buy a multitude of assets relatively cheaply. Instead of spending $1,000 for shares of a single company, you could spend the same amount on a fund that holds the same company plus many others. That’s a cheap way to diversify your assets and hedge against risk.

Mutual fund companies are generally run by managers who pay close attention to how assets are performing. If you don’t have the time or expertise to monitor various investments, then putting money into a mutual fund can be a safer, more practical way to invest.

1. Target-date funds.So-called target-date funds are popular relative newcomers and are designed to take the stress out of investing. They are designed to keep investors on track to hit retirement goals by putting more asset allocation decisions into the hands of the managers who run them.

Like other mutual funds, target-date funds invest in a diverse array of stocks, bonds and cash. Many are funds of funds — that is, they are composed of several other funds. As time passes, target-date funds automatically rebalance their holdings to become more conservative.

But convenience comes with some warning. These funds’ one-size-fits-all approach is misleading since funds can differ greatly, depending on who runs them, says Paul Mladjenovic, a certified financial planner and author of “Stock Investing for Dummies.”

“The mix will depend on the fund administrators. All the firms that have plans have different presumptions in place, so some are more growth oriented, some less so. When you choose a target fund, look at the categories that make up the mix for that particular fund,” says Mladjenovic.

You can investigate target-date funds at www.morningstar.com, where you can compare the underlying assets of the funds as well as performance history and expenses. Here again, personal advice from a financial adviser may help.

2. Index funds and managed funds.When it comes to picking a mutual fund, it’s easy to feel overwhelmed. You’ve got thousands of different choices.

But you can make quick work of organizing your options by dividing the fund universe into two basic categories: index funds and actively managed funds.

Index funds are designed to replicate the performance of a particular market index, such as the Dow Jones Industrial Average or the Standard & Poor’s 500.

A quick refresher course
The Dow is made up of 30 leading domestic companies such as Alcoa, General Motors and Microsoft, and its overall performance is used as a bellwether of the overall economy.

The 500 large-cap stocks in the S&P 500 represent leading actively traded U.S. companies. Many mutual fund managers pit their performance against that of the S&P 500 index.

Index funds are pretty straightforward, since their holdings mirror that of an index. As Paul Mladjenovic, author of “Stock Investing for Dummies,” sums up: “Index funds can be run by one person and a computer.”

Actively managed funds are an entirely different story. With these, a mutual fund manager or team of managers buys and sells a variety of holdings in an attempt to beat their respective index. Therefore, portfolio turnover is generally higher, the funds are less tax-efficient and they require more hands-on management.

In the end, all that activity often doesn’t guarantee top returns.

It’s not that fund managers aren’t smart enough to beat the indexes. But in general, most actively managed funds come with higher annual expenses that eat into performance and profits, making it difficult to beat index funds. Over the past 10 years, the cheapest S&P 500 index funds beat more than 60 percent of their large-cap blend peers, according to Morningstar.

As an example, the expense ratio for large-blend index funds currently averages 0.59 percent, but the annual expense ratio for an actively managed large-blend fund typically runs 1.22 percent, according to Morningstar.

That may not sound significant, but don’t be fooled. A seemingly “small” difference in expenses can be worth a small fortune over time.

The difference fees make
Scenario: Imagine two investors with $10,000 each and deep convictions about how to invest their money. One puts his money in an index fund that returns 10 percent minus 0.20 percent in expenses. The other invests in an actively managed fund that also returns 10 percent annually, but its performance is dragged down by an expense ratio of 1.22 percent. Both leave money in their respective funds for 35 years.
  • The index fund is worth $263,683 after 35 years.
  • The actively managed fund is worth $190,203.
  • The difference is $73,480.

Taxes are another consideration. Remember, Uncle Sam wants his piece of the action when you sell winning investments. Because actively managed funds reshuffle their stock holdings far more frequently than index funds, they trigger more taxes than index funds, which have a buy and hold approach.

The bottom line: With their low costs and generally higher returns, index funds generally are the best bet for most investors.

3. Exchange-traded funds.

Mutual funds have their limitations. For starters, the actively managed variety passes overhead costs (research and management expenses) on to investors, which eat away at returns.

Funds also distribute capital gains at the end of each year, a taxable event for shareholders — even in years with negative returns. This is true of both actively managed and index funds, though the latter are more tax efficient.

And, because they get priced once daily at the close of the trading day, funds aren’t flexible enough for investors who wish to take advantage of short-term dips and spikes in the market through intraday trading.

ETFs boom

Enter the more sophisticated exchange traded fund, or ETF, which arrived on the scene in 1993 and has fast become the investment tool of choice for Wall Street and Main Street investors alike.

ETFs, which track the performance of a stock or bond index, are much like index funds, with a bit more bling.

Offering broad market exposure, tax efficiency and lower operating costs, they are designed to pick up where mutual funds leave off.

“One of the chief benefits of the ETF is that they tend to be significantly cheaper than conventional mutual funds,” says Sonya Morris, editor of Morningstar ETFInvestor, though some index funds offer competitive expense ratios, she adds.

ETFs are baskets of securities bought and sold on an exchange, not unlike individual securities.

Among the more popular ETFs are Spiders (SPY), so named because they track the Standard and Poor’s 500 index of large-cap stocks. Diamonds (DIA), meanwhile, track the Dow Jones Industrial Average, while Cubes (QQQQ) follow the stocks held in the Nasdaq 100 Index.

ETF prices fluctuate real-time throughout the day, making them well-suited for individual investors engaged in intraday trading.

They can also be bought on margin — using borrowed money — and sold short for those betting on a market slide.

Another bit plus of the ETF is that, because they don’t have to sell underlying securities to meet redemptions, they rarely distribute taxable gains to shareholders. ETF investors sell shares to other investors.

ETF weakness

Anytime you trade an ETF, notes Morris, you pay a brokerage commission, making them less attractive for active traders and anyone using a dollar-cost average investment strategy (those who buy into a position with small, periodic investments over time).

At the same time, the flexibility to trade ETFs like stocks can also become a pitfall for some investors. “Unfortunately that encourages investors’ worst instincts — to chase past performance,” says Morris.

Characteristics of index funds and exchange-traded funds
  Index mutual funds ETFs
Generates taxable distributions beyond investors’ control Yes No
Offers broad diversification Yes No
Low expense ratio Depends Yes
Triggers brokerage commissions No Yes
Allows intraday trading No Yes
Can be bought on margin or sold short No Yes
Appropriate for dollar cost averaging Yes No
Allows reinvestment of distributions Yes No

Despite their growing popularity, ETFs remain largely unavailable to investors through 401(k)s and other employee-sponsored retirement plans, which often restrict their offerings to mutual funds.

Those considering new investments for their personal portfolio, however, should weigh the pros and cons of ETFs and mutual funds against their need for tax efficiency and flexibility.

Promoted Stories