Investing 101: What Stocks, Mutual Funds, Exchange-Traded Funds (ETFs), & Dividends are
My goal was to show an overview of stocks, mutual funds, index funds, registered plans and exchange-traded funds (ETFs) in one image, so here it goes:
This is not a perfect analogy, but it is good enough to put things into something less dry / technical so that it is easier to understand.
If at the end of this post, you can use these analogies and re-explain it to someone completely brand new who has no clue about what stocks, funds, etc are, then it is a successful post for me.
Imagine each flower or plant is a company
Imagine every type of flower or plant 🌹🌺🌸🌼🌻🌿☘🍀 is a company.
Each 🍃🍂🍁 petal or leaf is a single stock that has been issued publicly, in something called an “IPO” or an Initial Public Offering.
So if a rose has 20 petals, the rose is a company, and there are 20 petals or shares.
So with our example above, you can grow a rose at home in your backyard, or you can grow it, cut it, and then take it to the market and sell it to a stranger to bring home to their home.
An IPO is just like that — it happens when a company that is privately owned, decides it needs to “go public” and start selling PART of its company in a form of shares. So they take their homegrown, backyard rose, and shop it around to people milling around at the farmer’s market to try and get them to buy it.
Before they do that, they decide how much of the company they want to sell publicly in the form of shares (the amount), and how many shares they want for it.
In very simple terms: $20,000 for 20,000 shares = $1/per share offered at the IPO
Mutual funds are the different bouquet arrangements
Think about all the different bouquets you can have:
You can have two roses 🌹🌹 (50 shares of a company), eucalyptus branches 🌿 (100 shares of a company), and a single leaf 🍃wrapped around it (1 share of a company).
Or you can have 7 peonies, 3 orchids, and a few lavender branches with 7 green leaves as a background.
Each of these bouquets or arrangements of different flowers (companies) are exactly like a mutual fund’s makeup.
You can have different arrangements of bouquets – one for technology 📺, another for energy💥, or for dividends🍎, all with different flowers and plants (companies/stocks!)
They all have different or the same flowers (companies), but they are all not exactly the same bouquet unless they are INDEX mutual funds.
Index mutual funds are the exact same bouquet arrangements sold by everyone
Index mutual funds are if you can buy this exact orange rose bouquet arrangement 👀 anywhere, from the florist to the sidewalk vendor 🚪.
Example: S&P 500 index/tracker fund that holds 500 flowers (companies), or the TSX index/tracker fund (~230 flowers).
You could literally go to any florist and they ALWAYS have a dozen roses (S&P 500) for sale, and they sell them at different prices, just like how banks sell the SAME index mutual fund but for different prices (the prices are the management expense ratios, but more on that later).
Your registered plans are containers like vases or jars
Your vase, watering can or basket 🍶🍯🥛🥃 to hold these individual flowers or bouquets, are simply your tax registered plans like your RRSP / TFSA, 401K / Roth IRA or Supers.
You have the watering can for your RRSP / 401K, maybe a glass jar for your 401K / Roth IRA, and a vase for anything outside of those plans.
All these different vessels are different ways you can put flowers/bouquets inside of.
They’re completely empty to begin with – you do not have the empty vase and then expect flowers or plants to magically appear right? You have to then go out and get the flowers or plants to fill it, right?
Same thing as with stocks and mutual funds.
Picking what to fill it with like stocks or mutual funds, is just like picking flowers or plants — Do you want a dozen roses only? Maybe a few peonies? Some baby’s breath? These are all decisions you have to make depending on what you want at the end of the day.
Financial institutions are where you can purchase these flowers / bouquets
You can buy these flowers or bouquets at the Farmer’s Market (Discount Brokerage) or at Florists (different Banks or financial institutions).
There are so many options out there — Questrade (Canada only), Vanguard (U.S. only but you can buy Vanguard Canada ETFs), TD Bank, Chase, Fidelity, ScotiaBank, just to name a few American & Canadian places where you can buy bouquets or flowers.
You can choose to go to any florist you want!
But they will all charge different prices depending on their pricing structure. The cheaper florists or sidewalk vendors are going to be cost-effective versus going to an upscale florist.
Exchange Traded Funds (ETFs) just depend on how you want to buy the bouquet
The ONLY difference is HOW you buy them.
Let’s say you want those dozen roses as a bouquet – you can buy them at your expensive florist around the corner, or you can buy them via a sidewalk vendor who has them in a plastic bucket on the ground.
It’s exactly the same bouquet of 12 roses, but you will likely pay more at your expensive florist (customer service, they offer you tea and coffee when you show up, they look really nice and friendly), than if you buy it from a sidewalk vendor who just wants money (almost no customer service, totally transactional).
It is the same for ETFs versus mutual funds. You can buy the same mutual fund either at the bank for slightly more money, or buy it as an ETF on the stock exchange where it is traded as a stock that you buy/sell via a brokerage (discount or not).
How much you pay for the bouquet is the management fee or MERs
As mentioned above – your expensive florist will charge you more for 12 roses because of the atmosphere, service, etc. But you can buy those same 12 roses at a sidewalk vendor for cheaper.
That is the same principle for management fees or MERs (‘management expense ratios’).
You can choose to pay more to have the florist (your bank) always have a lovely calligraphy-flourished card ready for you to sign, and the 12 roses beautifully packaged, every year you need to send flowers, or you can do it yourself, walk down to the sidewalk vendor, buy the same 12 roses, figure out the card situation yourself (DIY!!! DO IT YOURSELF) and grab some ribbon to tie it up (discount brokerage).
You’ll save let’s say 3% on the costs, but over time, if you’re buying these bouquets monthly, this 3% adds up.
In real portfolio terms, it can be over $100,000 over the lifetime of your portfolio.
If let’s say you have $500,000 in your portfolio.
If you pay an extra 1% for the florist to package and have everything ready for you, that’s $5000 a year.
$5000 a year x 20 years = $100,000
That’s one hundred GRAND you could have kept in your pocket over the next 20 years by figuring out how to buy the card yourself and getting organized.
Now if you look at 1% over 40 years of saving if you’re really young, it is about $590,000 in lost money (this includes compounding interest on the lost money/earnings) just because you paid an extra ONE PERCENT to your bank for the EXACT same bouquet of 12 roses (mutual fund). (Source: Nerdwallet)
The seeds (if any) are dividends
Just like with flowers, not all of them give off seeds in abundance so you can plant and re-grow more and more flowers to build an empire and the seeds are dividends.
Sunflowers for instance give off a lot of seeds so you can plant more and more sunflowers to have a whole field (I used to run in one when I was a little girl!)
Other flowers, like roses, don’t give off any seeds where you can take them and replant to get more roses, and that’s okay, because not every company gives out dividends. It is why I have a dividend investing strategy and this is why I do it.
And that’s it in an nutshell.