Stock & bond investing - a gentle intro (part 3)

The epic trilogy reaches a long-awaited finale.

Feb 08, 2025

So far we learned that stocks are ownership and bonds are debt in Part 1. Then in Part 2, we discussed why it’s rational for most people to avoid selecting actively managed equity funds, and to instead buy broad index funds. A cap-weighted index fund doesn’t make you a “passive investor” except in one way: you’re electing to agree with market prices when you invest, rather than disagree by emphasizing certain favored stocks.

This is a good conceptual foundation, and now we can cover some details that everyone needs to know before hitting the “buy” button in their brokerage account. So let’s start with those accounts.

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Brokerage account

A brokerage account is the standard investing account, with no limit on how much money you can contribute and invest. The investments are taxable, which is why I’ll sometimes call it a “taxable account” for clarity. Other account types (like retirement accounts) are tax-advantaged. Opening a brokerage account is similar to opening a checking account, with a few extra questions to answer.

Four of the largest brokerage firms in the US are Fidelity, Charles Schwab, Vanguard, and E*Trade. Although any of these is a fine choice, my general recommendations are Fidelity and Schwab. Of course, I don’t know your preferences, so you can try any number of accounts. There are no fees for opening or maintaining an account.

Fidelity and Schwab are at the top of my list because their offerings are so comprehensive. Fidelity’s feature development has been especially impressive in recent years. In particular, their automation tools allow you to schedule recurring money transfers and trades, so you can invest part of each paycheck without logging into your account. I think automation is so important, which makes it hard to recommend any other mainstream broker at the moment. Schwab, E*Trade, and Vanguard have more limited automation features.

Companies like Schwab that broker trades are distinct from those that manage assets. BlackRock, State Street, and Invesco are large asset managers: they operate investment funds like BlackRock’s S&P 500 index fund, which we mentioned in Part 2. However, some companies have a foot in both worlds: Vanguard, Fidelity, and Schwab are asset managers on top of their brokerage business. Schwab is also a large bank, with a useful checking account that reimburses ATM fees even when traveling internationally.

So don’t sweat your choice of brokerage account: try out two or three, or just pick Fidelity.

ETFs and mutual funds

A fund can be structured as a mutual fund or an exchange-traded fund (ETF). Both can be actively managed or track an index: the fund structure has no inherent relationship with the management style. The mutual fund is an old beast, whereas the first ETF originated in 1990 in Canada. The first ETF in the US launched in 1993, and is still the largest and most-traded ETF today. ETFs have some major advantages over mutual funds.

Let’s clear up one phrase: instead of the “share price” of a fund, you’ll often see “NAV” (net asset value). Technically, they’re not interchangeable terms.1 Practically, all an investor needs to know is that NAV = share price of a fund.

Because ETFs are exchange-traded like stocks, many aspects of ETFs and stocks are shared. They both trade at varying prices throughout the day and can be bought and sold anytime during market hours (9:30am-4pm ET, Mon-Fri). Shares are purchased discretely — you can buy 6, 14, or 23 but not 6½. So if the share price of an ETF is currently $60, an investor can introduce money into the fund in multiples of $60.

Like stocks, ETFs have a bid-ask spread. For most investors, the spread is the main transaction cost of trading ETFs and stocks. It means that at any given instant, the price at which a share can be bought is slightly higher than the price at which it can be sold. For example, the price at which shares can be bought might be $116.13 while the price at which they can be sold is $116.11. The share price is defined as the midpoint, which is $116.12. So the bid and ask prices are the real prices that sellers and buyers encounter, while the “share price” is an abstraction that lets us quote a single number for convenience.

Mutual funds can be transacted only once per day. The NAV is updated after market hours have concluded at 4pm based on the fund’s net gain or loss that day. All orders to buy or sell since 4pm the prior day are executed based on the new NAV. Instead of being traded on an exchange like stocks, shares are transacted directly with the fund. There is no bid-ask spread: investors buy or sell at the same price on a given day.

Many mutual funds have no minimum investment, but some do. Notably, many Vanguard mutual funds have a $3,000 minimum initial investment. But the share price is immaterial: you can introduce any dollar amount into the fund. If you invest $5,000 and the NAV is $15, you would purchase 333.333 shares.

Okay, so you can’t buy and sell a mutual fund all day. But a long-term investor wouldn’t want to do that anyway. What makes ETFs great?

Every ETF is available in every brokerage account. Mutual funds are limited in any brokerage account — some are simply not available to purchase. If you buy mutual funds in a Fidelity account, there’s no transaction fee if the funds are managed by Fidelity. But if a mutual fund is managed by someone else, like Vanguard or Schwab, you'll often pay a transaction fee (if the fund is even available). The situation is similar when using a Vanguard or Schwab account.

So you can buy shares of a BlackRock ETF in a Schwab brokerage account, or shares of a Vanguard ETF in a Fidelity account. With ETFs, your choice of funds isn’t tethered to your choice of broker.

Mutual funds can have additional types of fees that ETFs never have, which is a potential issue in work retirement accounts like a 401(k). But in your taxable account, extra fees aren’t a concern as long as you stick with low-cost mutual funds from mainstream managers like Fidelity, Schwab, and Vanguard.

Stock ETFs are more tax-efficient than stock mutual funds, which is the best reason to avoid stock mutual funds in your taxable account. We’ll explain further in a minute.

Capital gains and dividends

In this section we’ll start with stocks, then compare them to stock and bond funds. Holding a stock can increase your wealth in two ways: capital gains and dividends. If you buy shares at $85 and the price increases to $90, that is a capital gain, because you can sell the shares for a profit if you choose. If your shares rise in value but you haven’t yet sold, you have an unrealized capital gain. When you sell the shares, you realize the gain.

Capital gains in stock and bond funds work the same way: the share price of a fund rises when its holdings increase in value.

A cash dividend is also pretty simple: the company transfers cash to its shareholders. Specifically, an ex-dividend date (AKA ex-date) is declared in advance. Those who own shares at the end of the day before the ex-date will receive the upcoming dividend on the payment date. This happens regardless of whether they sell some or all of their shares before the payment. Those who buy shares on or after the ex-date will not receive it.

A careful reader might then ask, could I make money by purchasing right before the ex-date to collect the dividend, without holding the stock for long? Alas, dividends aren’t the “free money” some people think they are.

Let’s say ABC company declares a quarterly dividend of $0.65 per share, and you own 100 shares. Each share would be worth roughly $0.65 less after the dividend, because that cash departed the company. All else equal, the price would fall by the dividend amount on the ex-date, robbing you of your free money.

At least, that’s the standard explanation. Does it really happen in practice? The evidence indicates that stock prices fall by less than the dividend amount, suggesting that investors appraise a dividend by its after-tax value.2 That makes sense: the pre-tax dividend amount isn’t its real value (except to those investing in tax-advantaged accounts).

Still, the takeaway is the same: a dividend isn’t free money, because a company falls in value when it transfers cash to its owners.

Since you own 100 shares of ABC, $65 would land in your brokerage account on the payment date. There’s no single best practice for what to do with your dividends. The simplest and most effortless approach is to adjust your account settings so that all dividends are reinvested automatically. In this case, your $65 would promptly buy more ABC shares. Dividend reinvestment automatically buys fractional shares, so $65 would buy slightly more than one share.

Capital gains have an advantage as a way to raise cash. When you realize capital gains, you can choose to liquidate your investments at the right time and in the right quantity. Dividends are paid out and taxed regardless of whether you presently need the income.

Let’s switch back to funds. Stock funds receive cash dividends from the companies they own, and bond funds receive coupon payments from bond issuers. They pass on these payments to fund shareholders (like you) in the form of cash dividends. But for a fund, cash dividends are only one kind of distribution. A distribution is what it sounds like: a payout from the fund to its shareholders. Just like a stock price falls after a dividend — all else equal — any distribution causes the NAV to fall on the ex-date.

Aside from a cash dividend, the most common distribution is a capital gains distribution. It represents the taxable, realized net gains that a mutual fund is required to pass on to its shareholders at least once per year. Unfortunately, the fund’s capital gains don’t always match your capital gains from investing in the fund, so this can be a significant source of unexpected tax.

Stock ETFs have a lower tax burden because they almost never have to distribute capital gains. You can hold a stock ETF for many years and defer tax on gains until you sell shares.3 The distinction isn’t as important for bond funds, because bond ETFs sometimes have to distribute capital gains.

So as I warned above: buy stock ETFs, not stock mutual funds, in your taxable account. That includes target date mutual funds, which are managed for investors in retirement accounts who don’t have to worry about taxable distributions. Vanguard landed in hot water over this in 2021 when they inadvertently triggered huge capital gains distributions in a few of their target date mutual funds. It didn’t matter to most of the shareholders, but some of them were using taxable accounts. Vanguard eventually agreed to pay over $100 million in restitution to those shareholders. That’s an extreme case, but you can avoid similar issues by holding stock ETFs in your taxable account.

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Total return

Total return is the key performance measure of any security. It’s the combination of capital gains plus all distributions, assuming immediate reinvestment of distributions. It allows fair comparison between securities, because no two funds or two stocks have identical distributions. Total return reflects the actual experience (before tax) of an investor who automatically reinvests their distributions.

If you check the price return of a security — how much the price has increased or decreased — you may underestimate its total return. Dividends and other distributions always add to total return (there’s no such thing as a negative dividend).

Total return is generally illustrated by showing how an initial investment of $10,000 would have changed in value over time. See the chart for this cap-weighted US stock ETF called “Growth of Hypothetical $10,000”. Portfolio Visualizer has great tools to compare the total returns of different funds.

More about funds

Earlier I said that you can buy 6 or 23 shares of an ETF, but you can’t buy 6½. That’s true: your brokerage can’t go to the New York Stock Exchange and find 6½ shares to sell you. But it was also a lie: they can see that you want to buy 6.5 shares, Wise Long-term Investor Sally wants 2.3 shares, and Degenerate Day Trader Danny wants 11.2. They know they need 20 shares total, and they can create “fractional shares” by dividing one among their clients.

Buying a fractional share whenever you want is a recent development. Previously, fractional shares for stocks and ETFs were confined to automatic dividend reinvestment. So if you use a brokerage (like Fidelity) that offers fractional shares for ETFs, the drawback of discrete ETF shares has been remedied by this feature. If you want to transfer your account to another company, you can’t take your fractional shares with you because they’re an artificial construction at the brokerage level. That just means you have to sell a fraction of a share and transfer the cash instead.

Funds cost money to operate, so they charge fees to their shareholders. Broad market index funds can have remarkably low fees. Look for the “expense ratio” on a fund’s webpage.4 A .06% expense ratio for VT means you'll be charged six cents annually for every $100 invested in the fund. They won’t send you a bill for that: the fees are automatically withdrawn from the fund. So a fund’s returns are always presented after fees; you don't need to mentally subtract any fees when viewing past performance.

Expense ratios are an important part of selecting funds, although it’s possible to become overly preoccupied with tiny differences. Active funds charge higher expense ratios to support research, marketing, and well-paid managers. As a result, low-cost index funds get a head start: with the same return before fees, they would give a better return to investors.

A “basis point” is a convenient way to express a hundredth of a percentage point. An expense ratio of .15% can be expressed as 15 basis points. Basis points are abbreviated as bps, pronounced like “bips”. If Fund A returned 7.6% in a given year and Fund B returned 7.0%, we can say that Fund A beat Fund B by 60 bps (did you say bips?).

In Part 1 we covered that a company can split its shares into smaller pieces to keep the price of each share at a reasonable level. A fund can split its shares in the same way. Less commonly, stocks and funds can also conduct a reverse split to combine shares if the price is extremely low.

Mutual funds have distinct tickers that are always five letters ending in an X, like SWAGX and VTIAX. ETF tickers are two to four letters. They’re not distinguishable on sight from stock tickers, but they do follow some patterns. In many cases, Vanguard fund tickers start with a V, Schwab and State Street tickers start with an S, Fidelity tickers start with an F, and BlackRock tickers start with an I (for the iShares brand).

Investing is easy now

Investing used to mean accepting a heavy burden of fees. Many mutual funds had a large fee upon purchasing or selling shares, called a load. As recently as the 1990s, a load of 8% was typical for active mutual funds: you would pay 8% of your investment for the privilege of investing the other 92%. Expense ratios used to be much higher, often at least 1%. Commissions for purchasing individual stocks were high: it was common decades ago to pay your broker 1% of the value of the shares you were purchasing (or an expensive flat fee). And you had to buy shares in multiples of 100, or face even higher commissions. The need to buy at least 100 shares of each company meant that building a diversified portfolio of stocks on your own required already having a lot of money.

The first index funds launched in the 1970s, but didn't pick up significant assets for many years. With the advent of online trading, commissions for US stocks and ETFs eventually fell to less than $10. In October 2019, Schwab dropped their trade commissions from $4.95 to zero, prompting all other major US brokers to quickly do the same. That was the last step in a long move toward zero commissions that others in the industry had set in motion. Now anyone with a bank account can buy shares of VT and invest in the cap-weighted global stock market — over 9,000 stocks in more than 40 countries. It's a tax-efficient ETF with an expense ratio of .06%. This is a product even the wealthiest people couldn’t imagine in 1970: owning the global market for six basis points, while paying almost nothing to trade. Investors today are extremely fortunate compared to those in the past.

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That’s it for the basics of investing, congrats on finishing the trilogy! We’re going to move to other topics for a few weeks, but soon there will be more posts that take us deeper into the essentials of investing. See you next week.

Further resources

Every Money IRL post is organized in The Omni-Post, and all vocab terms are here.

If you haven’t already watched the videos I recommended in Parts 1 and 2, they’re super helpful additions to this guide.

Patrick Boyle, a London-based professor and former hedge fund manager, has a great YouTube channel with commentary on current events and important issues in financial markets. This playlist of his lectures on portfolio management is a good overview of many different aspects of investing.

The Plain Bagel is a Canadian finance YouTube channel with level-headed analysis of current events and various personal investing topics. Check out his explanation of fractional shares, and here’s another video about dividends.

A summary of all three parts of the gentle intro to investing is here.

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