We all know that it is quite important for an investor to have a diversified portfolio in order to succeed in the stock market. But in order to achieve the diversity of the stock portfolio, you'd need to invest in a lot of companies.
Many seasoned investors suggest that as an investor you should have a minimum of 25-35 stocks in your portfolio. How are you supposed to find the time and money to invest in those 25-30 companies?. That's where ETFs or exchange-traded funds come into play. With a single ETF, you can invest money in multiple companies and the best part is that you can start with a little amount of money which makes it a great option for newbie investors.
ETF Explained
An ETF or exchange-traded fund is a type of investment that involves a collection of investments such as stocks that usually track an index, although they can invest in the different numbers of sectors.
An ETF can hold multiple underlying assets rather than only one like a stock thus makes it a very effective option for diversification of investment portfolio.
ETFs are in many ways similar to mutual funds however they are listed on exchanges and share trade just like ordinary stocks. The price of an ETF's shares will change throughout the day as the shares are sold and bought on the market. ETFs tend to be more liquid and cost-effective when compared to mutual funds.
Some well-known example is the SPDR S&P 500 ETF which tracks the S&P 500 index. ETFs can contain many types of investments like bonds, stocks, commodities, or a collection of investment types.
Types Of ETFs
There are different types of ETFs available in the market that can be used for income generation, speculation, price increases, and to partly offset risk in an investment portfolio. Here are some common types of ETFs :
Commodity ETFs
Commodity ETFs invest in physical assets, like silver, gold, oil, coal, and natural gas, etc.
Sector ETFs
Sector ETFs focus on specific industries within the overall market. For example, you can invest in energy or health care ETF. Investing in a sector ETF is a good option if you think a certain segment of the economy will grow in the future but don't want to invest in individual companies.
Broad-Market Stock ETFs
Broad-Market Stock ETFs track the performance either of a large part of the stock market or overall stock market. Those with the broadest exposure are also called total market funds.
Inverse ETFs
Inverse ETFs attempt to earn profit from stock declines by shorting stocks.
Currency ETFs
Currency ETFs invest in foreign currencies such as the Euro or Canadian dollar.
Bond ETFs
You can find Bond ETFs that invest in specific varieties of bonds, for example, corporate bonds, municipal bonds, treasuries, or those that invest across the entire bond market which are known as broad market bond ETFs. If you are someone who needs fixed income like retirees then investing in bonds can be a good strategy for you.
Are ETFs A Good Investment? Here Are The Pros & Cons
So the question is whether ETFs a worthy investment or not?. The answer boils down to what the ETF is invested in. But in general, we can understand by comparing the pros and cons of ETFs.
ETF Pros
Instant diversification: You can invest in hundreds or even thousands of companies with a single purchase.
Lower Risk Compared To Individual Stocks: The diversity that ETFs offer protects you from losing big if one investment performs poorly.
Easy to buy and sell: You can sell them throughout the trading day on stock exchanges.
Low fees: These are some of the cheapest investments, fee-wise because they are not actively managed.
Tax Efficient: ETFs often come with a lower tax bill than mutual funds.
Transparency: You can verify what your money is invested in pretty much in real-time using the prospectus on the ETF website or by entering the ticker on a free website, like Yahoo! Finance. Mutual funds, by contrast, are only required to disclose their holdings on a quarterly basis.
ETF Cons
Less Chance Of Getting Big Rewards: The downside of diversification is that you don’t earn big if one investment skyrockets.
Still Some Risk: ETFs aren’t guaranteed to make money and can also lose money if the stock market drops or the sector you’ve invested in performs poorly.
While investing in ETFs, you can set yourself up for long-term success easily by practicing the rule of dollar-cost averaging (deciding how much you can afford to invest without worrying about the daily market activity). The best way to do this is by budgeting a certain amount you want to invest on monthly basis.
Before investing in ETFs, it's important to understand that just like the stock market ETFs will have good days and bad days, so don't act emotionally. ETFs are not a get rich quick scheme, your goal should be long term growth, not short-term profit. ETFs do not give a 100% profit guarantee, therefore don't invest money in them that you might need in the near future.
If you are someone who is very new and don't know anything about investing, you can start here.
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