Money Smarts Blog
Investments 101: What is an ETF?
Mar 7, 2019 || Elizabeth VanCamp
Whether it’s for retirement, a new home or paying off debt, everyone has something they’re trying to save for. I’m here to give you the details on four types of investments (stocks, bonds, mutual funds and ETFs) you may not know much about that could be game changers for your savings goals.
My family has a history of investing in stocks, going back to my great-grandpa, who was a banker and knew the importance of investing in the stock market. I, however, don’t have any current investments in the stock market, mostly because until recently, I didn’t understand how stocks worked. Upon realizing I needed to rev up my retirement savings a few months ago, I learned a lot about investment options and found that, if you’re saving for a big life event (like retirement), you should be investing in stocks.
For whatever reason, 46% of Americans are like me and don’t currently own any stock. If lack of understanding is the reason you haven’t bought stocks yet, let’s change that.
When you buy stocks, you’re buying shares in a company that have a certain value. You own a small part of the company. A company issues shares so they can receive cash to complete projects or grow the company. As a company grows and increases its value, the value of each share grows too. If you think of a company’s value as a pizza, the larger the pizza gets, the larger each slice (or share) will be.
You buy stocks at a certain value, and you can sell your shares at a loss (your shares have less value than when you bought them) or a gain (you sell for a higher value than you initially paid). So, if you own four shares of stock which you purchased for $50 each, but now they’re valued at $75 each, you could sell and gain a profit of $100. See why investing in stocks seems so appealing?
But wait. Nothing in life is that simple. Purchasing stocks is often a game of patience. If you invest in a company which has a good reputation and growth, there’s a good chance your investment will grow, too. However, something as simple as a bad rumor or one slip up could cause your share value to go down. If you’re investing over a long period of time, your investment will likely recover from the ups and downs of the market. But if you’re investing in a limited number of companies or for a short period of time, you might feel the negative impacts of market fluctuations a bit more.
How to Buy Stock
To get started, you’ll need to open a brokerage account, which—lucky for you—is really easy to do. Check with your financial institution to see if they offer investment services, but if they don’t, there are a lot of online brokerages that can get you started and help you reach your savings goals.
When perusing the various brokerages you can choose from, make sure to take their fees and charges into consider. You may want to look for low trade commissions, especially if you plan to be an active trader; but you’ll also want to consider investment minimums and their range of advice.
If you don’t feel comfortable jumping into stocks just yet, start with a low-pressure option by opening a 401(k) through your work or an IRA on your own. Both options use stocks (and other securities) to build your investments and are super valuable tools for saving for retirement. Plus, since you’ll have some control over your investment options, you’ll be getting the best of both worlds!
My great-grandpa, who I mentioned earlier, always invested in bonds for his grandchildren for birthdays and other big life events. When I bought my first home, I cashed out my bonds from him to use as part of my down payment. These were investments in my future that he made 20 years before I needed them. Pretty cool, huh?
Think of a bond as a loan from you to a corporation or the government. For example, a company may issue bonds to investors to finance projects. So, if you’re one of those investors, you’re loaning the company money to complete their project with the expectation that your loan will be paid back with interest.
Breaking Down Bonds
Bonds have a face value, which is the value that’s paid back when a bond matures. A bond’s maturity date is like the date you owe your last mortgage payment—it’s the day the bond will be paid back in full. Bonds also have what’s called a coupon rate, which is the percentage of your investment you’ll be paid every year as a thanks for lending your money.
For instance, if you purchase a 10-year bond with a face value of $200 with a 5 percent coupon rate, you’ll receive $10 (5 percent of 200) every year until the maturity date of the bond, plus you’ll then receive the full face value ($200) of your original investment. Altogether, you’ll receive $300 throughout your bond’s life, giving you a $100 gain.
Sometimes you can purchase a bond for more (premium) or less (discount) than its face value on the market. There are different market scenarios that might this appealing, but either way, you’ll still receive the full face value at the maturity date.
Why to Invest in Bonds
Bonds are more conservative than other investment securities so, while they can’t guarantee as big of returns as some other investments, they can guarantee the same coupon rate (no variation in interest payments) and that you’ll receive the full face value at the maturity date. Stocks give you an opportunity to receive higher returns, but they can’t guarantee stable interest rates or that you’ll receive at least your initial investment when you sell your stock.
It’s important to diversify your investments, and investing in bonds is an easy way to do that. Don’t put all your eggs in this one basket because you stand a very good chance of receiving higher returns from stocks. Definitely consider purchasing bonds this year to diversify your portfolio and secure some good investments for your future.
A mutual fund is an investment in multiple types of securities (stocks and bonds) in one step. There’s built-in diversification because you’re making one investment in a mutual fund, but that fund is made up of multiple securities. This gives your investment the opportunity to grow because, even though some of the stocks or bonds within the fund may under-perform, other securities may be performing well. Diversification is king, folks!
With mutual funds, you gain access to a part of a group of investments by pooling your money with other investors. You’re not purchasing a mutual fund by yourself—you and many others own part of the fund together—and everyone who owns part of the fund shares in the fund’s performance.
Mutual funds are typically a hands-off type of investment, with a money/portfolio manager handling the planning and investing for you. So, if you don’t want to deal with the nitty-gritty of your investments and want built-in diversification, this might be a good choice to consider.
Just like most investments, there are fees associated with mutual funds. Fees can differ based on how passive or active you want your investment strategy to be. Active funds have higher fees because of the extra effort put into researching the best securities to invest in. Many people don’t think this approach is worth it, so they could consider starting with a more passive strategy.
How to Start Investing in a Mutual Fund
Mutual funds can be opened at a variety of financial and investment institutions (if they have an advisor), including credit unions, online brokerages, or investment firms. But before deciding where you should open one, you’ll need to decide if you want to tackle this yourself or have the help of a financial advisor and, if you choose the latter, whether you want your investment to be passive or active strategy.
You’ll also need to calculate your budget for investment; how much you can afford to invest. Deciding the right mix of investments for you is key as well, but if that feels too overwhelming, an advisor can assist you with this.
Exchange Traded Funds (ETF)
ETFs are similar to mutual funds in that both bundle several different securities into one investment. However, one major difference is that most ETFs track to specific indexes* or sectors, and are traded like stocks. This means they don’t require as much managing as mutual funds, so typically there are less costs. Additionally, there are low investment minimums, so that’s another perk of choosing ETFs over mutual funds.
*Stock indexes help track the performance of a group of stocks, such as the S&P 500 (which consists of 500 U.S. company stocks and is one of the best indicators of how the U.S. market is doing).
Another thing that makes ETFs the preferred choice for some investors is that they’re more tax efficient than mutual funds. You control the amount of tax liability when you sell ETFs. Mutual funds can trade securities more frequently, whether or not you sell your shares, therefore leaving investors open to more taxable events.
Are There Any Downsides to EFTs?
Yes. Unfortunately, like most things in life, ETFs aren’t perfect. Some things to be aware of when considering ETFs are:
- Because they’re traded like stock, you pay a trade fee (commission) each time you buy or sell
- If your ETF is tracking a specific sector, it has a greater chance of experiencing market volatility
- Some ETFs lack liquidity. You can learn how to study the spreads and market movements for ETFs before purchasing them, but if just reading this bullet point is making your head spin, maybe consider enlisting the assistance of an investment professional
- Although there are generally less trades and concerns related to capital gains with ETFs, not all ETFs operate the same way. Make sure you understand how an ETF handles capital gains distributions before investing in it
Now that you’ve gone through Investment Types 101, you can get excited about upping your savings game this year! Nail down your savings goals and start tackling them with stocks, bonds, mutual funds, ETFs, or a combination. No matter which one(s) you choose, investing your extra income is going to make a much bigger difference than just leaving it in a savings account.