Content of the material
- What is an ETF?
- Pros and cons of ETFs
- Rate of Return
- 4. Understand Investing Risks
- Bank smarter
- Invest Smarter with The Motley Fool
- Starting Balance
- Your Results
- What’s the best way to invest money for the short term?
- Where to invest your money
- Create a Spending Plan
- Invest According to Your Risk Profile
What is an ETF?
ETF stands for exchange-traded fund. An ETF allows you to purchase a large number of securities – stocks, bonds or commodities – all at once.
You can think of an ETF like a grocery basket but instead of filling your basket with eggs and milk, you fill it with stocks or bonds. And, instead of purchasing each item individually, you purchase the entire basket all in one go!
Like an individual stock, ETFs are traded on an exchange throughout the day and there are tons of ETFs to choose from. Some ETFs are full of stocks, some hold bonds, and other track the performance of a certain market sector (health care, pharmaceuticals or communications) or a certain index (S&P 500 or Dow Jones).
Pros and cons of ETFs
You might be thinking, “Wow, ETFs sound pretty great!” And you’re right, ETFs are great — but they’re not perfect. Before you decide if an ETF is right for you, consider the pros and cons.
- Low barrier to entry – There is no minimum amount required to begin investing in ETFs. All you need is enough to cover the price of one share and any associated commissions or fees.
- Diversification – Rather than try to purchase every security individually (which would be extremely time consuming), you can quickly and easily purchase one ETF that contains an array of securities.
- Easy to buy and sell – ETFs are traded just like an individual stock. You can buy and sell at any point throughout the day.
- Tax-efficient – You don’t pay any taxes until you sell your ETFs at a profit. So you are in control of when you decide to sell and pay the necessary taxes.
While ETFs are pretty great, nothing is perfect. There are a few things to be aware of.
- Trading costs – while one of the benefits of ETFs is that they typically have lower fees than mutual funds, you still might have to pay fees when you make a trade. Although a lot of discount brokerages have instituted zero-fee trading, not all have.
- Volatility – ETFs are not immune to volatility. While purchasing an ETF may be more stable than putting all of your money into an individual stock, there is still potential for swings in the market. You can reduce your risk by purchasing an ETF that tracks the entire market (S&P 500 or Dow Jones) rather than purchasing ETFs in one market.
Rate of Return
When you’ve decided on your starting balance, contribution amount and contribution frequency, your putting your money in the hands of the market. So how do you know what rate of return you’ll earn? Well, the SmartAsset investment calculator default is 4%. This may seem low to you if you’ve read that the stock market averages much higher returns over the course of decades.
Let us explain. When we figure rates of return for our calculators, we’re assuming you’ll have an asset allocation that includes some stocks, some bonds and some cash. Those investments have varying rates of return, and experience ups and downs over time. It’s always better to use a conservative estimated rate of return so you don’t under-save.
Sure, you could count on a 10% rate of return if you want to feel great about your future financial security, but you likely won’t be getting an accurate picture of your investing potential. That, my friend, would lead to undersaving. Undersaving often leads to a future that’s financially insecure.
4. Understand Investing Risks
To avoid knee-jerk reactions to market dips, be sure you know the risks inherent in investing in different assets before you buy them.
Stocks are typically considered riskier investments than bonds, for instance. That’s why Francis suggests trimming your stock allocation as you approach your goal. This way you can lock in some of your gains as you reach your deadline.
But even within the category of stocks, some investments are riskier than others. For example, U.S. stocks are thought to be safer than stocks from countries with still-developing economies because of the usually greater economic and political uncertainties in those regions.
Bonds can be less risky, but they’re not 100% safe. For example, corporate bonds are only as secure as the issuer’s bottom line. If the firm goes bankrupt, it may not be able to repay its debts, and bondholders would have to take the loss. To minimize this default risk, you should stick with investing in bonds from companies with high credit ratings.
Assessing risk is not always as simple as looking at credit ratings, however. Investors must also consider their own risk tolerance, or how much risk they’re able to stomach.
“It includes being able to watch the value of one’s investments going up and down without it impacting their ability to sleep at night,” King says. Even highly rated companies and bonds can underperform at certain points in time.
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Say you have some money you’ve already saved up, you just got a bonus from work or you received money as a gift or inheritance. That sum could become your investing principal. Your principal, or starting balance, is your jumping-off point for the purposes of investing. Most brokerage firms that offer mutual funds and index funds require a starting balance of $1,000. You can buy individual equities and bonds with less than that, though.
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What’s the best way to invest money for the short term?
If you are likely to need your money in less than five years, it’s best to leave the money in cash rather than invest.
The stock market could fall in the short term, meaning you would lose money on your investments if you tried to take it out when the market was down.
But be warned, interest rates are historically low at the moment so you won’t get a great return.
Where to invest your money
You have countless options when it comes to choosing where to invest. One of those options is exchange-traded funds, or ETFs.
An ETF is a group of stocks consolidated into a single investment. So when you invest in just one ETF, you’re instantly investing in hundreds or even thousands of different stocks. This will help diversify your portfolio and reduce your risk.
While there are many different ETFs to choose from, a solid option is the Vanguard S&P 500 ETF ( VOO 0.55% ). This fund tracks the S&P 500 index, meaning it includes the same stocks as the index itself and mirrors its performance.
The S&P 500 is one of the best representations of the stock market as a whole, which can further limit your risk. The stock market is prone to volatility, but it has a long track record of bouncing back after crashes and corrections. Because this ETF follows the market, it’s very likely to recover from downturns as well.
Also, by investing in the S&P 500, you’re buying some of the largest and most successful companies in the U.S. A few of the biggest names in the S&P 500 include Apple, Microsoft, Alphabet, Amazon, and Facebook.
Create a Spending Plan
The mistake many people make when creating a personal spending plan is they determine their savings amounts around their monthly expenses, which means they save what they have leftover after expenses.
This invariably results in a sporadic investing plan, which could mean no money is available for investing when expenses run high in a particular month. People who are intent on achieving their goals reverse the process and determine their monthly expenses around their savings goals. If your savings goal is $500, this amount becomes your first expenditure.
It is especially easy to do if you set up an automatic deduction from your paycheck for a qualified retirement plan. This forces you to manage your expenses on $500 less each month.
Invest According to Your Risk Profile
This investment plan assumes an average annual rate of return of 6.5%, which is achievable based on the historical return of the stock market over the last 100 years. It assumes a moderate investment profile, investing in large-cap stocks.
If you are adverse to risk or prefer to include investments that are less volatile than stocks, you will have to lower your assumed rate of return, which will require you to increase the amount you invest.
At a younger age, you have a longer time horizon, which may allow you to assume a little more risk for the potential of higher returns. Then, as you get closer to your retirement target, you will probably want to reduce the volatility in your portfolio by adding more fixed-income investments. By staying focused on your benchmark of a 6.5% average annual rate of return, you should be able to construct a portfolio allocation that suits your evolving risk profile over time, which will allow you to maintain a constant monthly investment amount.