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If you were a part of the surge of new investors who bought stocks in 2020, well done! That’s a great first step. But there’s far more to the stock market than individual stocks.
By charting the right course now, you can build a convenient, low-stress investing strategy that also lowers overall risk. For many, that route is toward a portfolio primarily made up of exchange-traded funds — or any type of mutual fund, for that matter — not individual stocks.
What’s an ETF, anyway?
Imagine an ETF as a rainbow layer cake, and each color represents an individual stock. When you cut a slice, you’re getting a little bit of every color inside the cake.
Similarly, when you purchase an ETF, you’re getting a little bit of every stock in the ETF. The stocks included in the ETF depend on the index the fund is tracking; an S&P 500 ETF, for example, would distribute your investments across all companies in the S&P 500. There are also ETFs that contain other securities, such as bonds, precious metals or currencies.
ETFs can be traded throughout the day, like stocks, which isn’t an option with mutual funds.
» Learn more: What is an ETF?
4 reasons to consider ETFs
1. Easy diversification
Diversification sounds complicated, but it just means owning a broad range of investments. By diversifying, you’re spreading your risk; if one company in the ETF underperforms, the losses could be offset by companies that outperform.
“Owning a diversified portfolio is less risky than owning a handful of stocks,” says Jim Rowley, head of investor research for Vanguard Investment Strategy Group.
Rowley acknowledges that this isn’t a very glamorous approach, but if investors can avoid the lure of familiarity bias (that is, the urge to invest heavily in just the headline-grabbing stocks), they can lower the risk of investing in a company that significantly underperforms the market. And according to Vanguard’s research, choosing unwisely is not an unfounded fear.
“Over the past 25 to 30 years, the number of U.S. stocks that do better than 10 percentage points over the market, as well as 10 percentage points worse than the market, is about two-thirds,” Rowley says, meaning that on any given year, the majority of stocks either perform extremely well or extremely poorly — not at the market average as we might think.
If you’re actively picking individual stocks, there’s a slim chance of always choosing those stellar outperformers, and in fact, you may be just as likely to pick a severe underperformer.
Put simply, if you can ignore the temptation of chasing sky-high returns, broad diversification can help you earn market-average returns relatively more predictably while lowering the risk of below-average returns.
2. Hands-off investing
This is a hard truth, but new investors need to hear it: Stock picking is a gamble even for those well-versed in fundamental and technical stock analysis.
And if you can’t beat the market, join the market ... then forget about it.
The S&P 500’s annualized total return for the last 10 years was 13.8%. That means if you’d invested $5,000 in an S&P 500 ETF 10 years ago and set up automatic contributions of just $20 per month, that investment could be worth almost $25,000 today before inflation, taxes and fees — without you doing a thing. If spending time with friends and family or enjoying hobbies sounds better than fretting daily price fluctuations in front of a computer screen, then a hands-off investing approach is probably for you.
Rowley says that ETFs are sometimes overlooked as a hands-off, long-term investing engine simply because investors can trade them throughout the day like stocks. But this, he says, doesn’t preclude them from being an instrument of a hands-off strategy.
“Just because you can trade ETFs during the day doesn’t mean you must trade ETFs during the day,” he says. “They are great tools for a long-term investment.”
3. Simple portfolio management
Let’s say you have a healthy savings account, have already purchased your first stock, and are now looking to make regular contributions to your investment account (a strategy known as dollar-cost averaging). According to Rowley, this is where fund investing really starts to make sense.
“What happens when you have a portfolio of one or two or three stocks? Do you add a fourth stock? Do you concentrate your position even more by buying more of those one, two, or three stocks?” he asks. The point: Over time, building a portfolio of individual stocks can get complicated and costly.
ETFs, on the other hand, tend to only get easier. Every contribution (including reinvested dividends) is already diversified, creating a cycle that spreads risk over time and automatically keeps you from concentrating too much in any single stock.
4. Low costs
It’s true that ETFs come with fees (known as expense ratios) that aren’t charged by individual stocks. But today, many of those fees are extremely affordable. For example, several of the most popular S&P 500 ETFs have expense ratios of 0.03%.
That’s just 30 cents per year for every $1,000 invested — a tiny price to pay for proper diversification and a hands-off, long-term investment strategy that gets simpler over time, not more complex.