A Feisty Debate

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I'm 16 years old and want to invest $3,000. Should I go with mutual funds or ETFs?

QUESTION: I'm 16 years old. I've saved about $3,000 that I want to put away for use after college. I've been looking into ETFs and mutual funds. Which would you recommend?

ANSWER: Congratulations! Most people your age are far more interested in buying a car than a mutual fund. We predict a bright investing future ahead.

Your question is a good one. Exchange-traded funds (ETFs) have soared in popularity in recent years, and the debate over which is better -- ETFs or traditional mutual funds -- has become as heated as a Cheney/Edwards face-off. Like that debate, there's no obvious winner here. But by exploring the issues, hopefully we can help you decide which side of the fence you fall on.

You need to think about three things: how frequently you'd like to trade; how you'd like to allocate your investment; and whether you prefer active management or an indexing strategy. Let's tackle them one at a time.

First, your trading plans. Would you characterize yourself as a buy-and-hold investor, or do you want to trade frequently? And are you planning to invest more money in the future?

Many active traders like ETFs because, unlike mutual funds, ETFs are priced throughout the trading day, just like stocks are. (Traditional mutual funds are priced just once a day, at market close.) But the benefit doesn't come cheap. Investors must have a brokerage account to buy or sell ETF shares. That means you'll pay a sales commission each time you trade. "If you're only going to be working with a few thousand dollars, those transaction costs really add up," says certified financial planner Michael Kitces, director of financial planning at the Pinnacle Advisory Group in Columbia, Md. You'll also most likely be charged some sort of account maintenance fee.

If you go this route, online discount brokers like ShareBuilder, Ameritrade and E*Trade charge the lowest commissions, ranging from $4 to $22 per trade. For SmartMoney Magazine's picks on the best discount brokerages, click here.

By contrast, if you open an investment account directly through a no-load mutual-fund family, you generally won't be charged commissions or account fees. So assuming you don't have a burning need to day trade between English lit and psych 101, chalk one up for traditional mutual funds.

The second issue to consider is risk tolerance: Would you be comfortable if your account were to lose, say, 15% in one year? Generally, the longer the time horizon, the more risk an investor can afford to take. But risk tolerance is obviously a personal issue. Some investors are willing to risk losing more in the short term for a chance to make more money in the long run, explains Kitces. And for them, all-stock ETFs or mutual funds would probably be suitable.

But other investors watch their portfolios religiously, and wince at losing so much as a dollar. For risk-avoiders, diversification is critically important. With traditional mutual funds, you can easily achieve that by purchasing a blended fund (a fund that holds both stocks and bonds) or an asset-allocation type of fund, says Kitces. Both varieties of funds offer diversification in a single share. Of course, unless your plan is to withdraw all of your funds on graduation day, you probably don't need to be this conservative.

The larger question is, which type of investment vehicle do you prefer -- an actively managed fund or passively managed one? Passively managed funds come with low expense ratios, but are at the mercy of market events, hugging their benchmark indexes during good times and bad. (All ETFs are of the passively managed variety right now; the fund industry is working to roll out actively managed ETFs soon.)

Actively managed funds, by contrast, tend to have higher expenses, but they employ fund managers who choose which stocks or bonds to buy and sell, and when. The manager can control the portfolio, usually with the aim of beating the performance of the fund's appropriate benchmark, or matching the benchmark while limiting volatility. The key for an investor, of course, is to find a manager who's worth the extra cost. All too often, investors get stuck paying more for a sub-par performance.

Pretty complicated stuff, right? Lest you think investing is more tedious than calculus, just remember: It pays off. Consider this: If your account earns 6% a year (a relatively conservative estimate) for the next seven years, by the time you're out of college you'll have $4,500. Not bad. And if you decide to let it grow for, say, 50 years, you'll have $55,260 when you're 66. Now that's math that doesn't put you to sleep.