Exchange-traded funds (ETFs) are a type of investment that can offer many benefits. For example, a global ETF can offer diversification across different types of markets, countries, and sectors. With the right ETF, you’ll instantly have a more diverse portfolio than if you had invested in only a handful of stocks or bonds.
Another advantage of ETFs is that they can often be bought commission-free or at a very low cost. They are traded on stock exchanges, like normal stocks, and you can buy and sell them through a broker. Furthermore, the most popular ETFs tend to have low expense ratios, so it won’t cost you much to maintain your diversified investment.
Below are some popular investment and trading strategies beginners can use to get started with ETFs. Some of them are easily combined, while others may require more research and understanding to be implemented successfully. We’ll start with the simplest ETF strategies and move on to more complex ones.
The buy-and-hold strategy is one of the simplest and most popular ETF investment strategies. It involves buying a well-diversified ETF and holding it for an extended period of time, typically for years or even decades. This strategy aims to ride out the ups and downs of the stock market and ultimately achieve long-term capital appreciation or harvest dividend yields.
You can pick a few ETFs to create a portfolio that covers most of the global market. It could include different types of stocks and bonds from different markets, sectors, and countries. There are also global ETFs that come with this level of diversification already prepared.
One advantage of the buy-and-hold strategy is that it requires very little maintenance. New investors can simply purchase an ETF and hold it until they reach their desired target allocation or retirement date. Additionally, this strategy allows investors to avoid the often stressful task of trying to time the market.
Benefits of buy-and-hold
The stock market tends to go up over the long term, so the buy-and-hold ETF strategy is a good way to participate in market upside with the right amount of patience. Of course, there will be periods when the market declines, even extended ones, but if you can stomach the short-term volatility, you’ll likely be rewarded in the long run.
ETFs hold a group of stocks, so it is easy to create a diversified portfolio that includes stocks and bonds from around the world without needing to trade individual stocks. This diversification can help reduce risk because all investments are not likely to perform poorly at the same time.
That being said, not all ETFs are created equal, and some are more volatile than others. For example, an ETF that tracks global stocks can be a good way to diversify your portfolio across different geographies and sectors. However, if you’re looking for a more stable investment, an ETF that tracks government bonds may be a better choice.
Drawbacks of buy-and-hold
There are a few potential drawbacks to using the buy-and-hold strategy. First, investors may miss out on potential market gains if they buy an ETF near the top of a market cycle. In that case, it may be better to wait for a market correction before buying.
Second, this strategy requires a large amount of patience and discipline, as investors will need to ride out any market downturns. It’s easy to sell when things are going bad, and it’s just as tempting to buy when things are going well. A dollar-cost averaging strategy can help to mitigate this issue by buying into an ETF over a period of time rather than all at once.
Additionally, the buy-and-hold strategy does not consider changes in an investor’s personal circumstances. For example, an investor may need to sell their ETF holdings if they experience a change in job status or a major life event.
Dollar-cost averaging is another popular investment strategy among beginner and experienced investors. It involves investing a fixed amount of money into an ETF on a regular basis, regardless of the current market price.
By buying ETF shares at different prices over time, dollar-cost averaging can help to reduce the overall cost basis of your investment. This strategy assumes that the market will eventually rebound from any short-term declines, whether that takes months or years.
As such, dollar-cost averaging can be a good way to reduce the risk of buying ETF shares at the wrong time. On the other hand, this strategy will also miss out on potential market gains if the ETF is purchased after the market has already rallied.
Benefits of dollar-cost averaging
The famous American investor and fund manager Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” It’s widely believed by many academics and financial experts that timing the market is impossible.
This is why dollar-cost averaging can be such a powerful strategy. It takes the guessing game out of investing. By investing a fixed sum of money at regular intervals, you can avoid emotion-based decisions and become disciplined about your investing. Over time, this should help to lower your better cost per share than what you will get if you try to time the market.
Emotionally, it can be less stressful entering the markets one step at a time rather than jumping in with both feet. When investing a lump sum, there is always the risk that the market may crash immediately after you buy. This can hurt not only your investment portfolio but also damage your psyche. With dollar-cost averaging, the markets can still plummet after you make your investment, but it will be less painful because you’ve bought in gradually. Plus, if you’re sticking to your strategy, you’re buying on the dip later, which will lower your overall cost per share when the market recovers.
Drawbacks of dollar-cost averaging
Of course, there are also some potential drawbacks to this strategy. First, no one can really predict the future movements of the market. However, it’s still possible to have a common sense of when a correction may be coming. Looking at history, whenever there is a war, a pandemic, a supply crisis, or some other major event, the markets will usually get spooked.
It’s not that such occurrences always lead to a stock market fall, but there has historically been a correlation. When it happens, it can be beneficial to postpone investments for a while and wait for a lower entry point. While this defeats the purpose of dollar-cost averaging, it can potentially improve returns.
Another potential drawback of dollar-cost averaging is that it can take long to see any real gains, especially if you’re investing small sums of money. A 2012 paper from Vanguard titled “Dollar-cost averaging just means taking risk later” found that lump-sum investing outperformed dollar-cost two-thirds of the time. Based on this evidence and similar studies, investors should put everything in all at once. However, these studies ignore that many investors are uncomfortable with the idea that the market could go down soon after they invest a large sum.
Value averaging is a variation of dollar-cost averaging popularized by former Harvard University professor Michael E. Edleson. Like dollar-cost averaging, value averaging also involves investing a fixed sum of money into an ETF at regular intervals but differs in its approach as to how much to invest.
With value averaging, the size of each investment is adjusted so that it is proportional to the current value of your portfolio. The investor sets a target growth rate each month. They adjust the next month’s contribution based on how much the investment grew or shrank in the previous month. When the value of the portfolio falls, you buy more shares. When the value of your portfolio rises, you buy fewer shares.
For example, say you set a quarterly target growth rate of €1,000 as your target. In the first quarter, you would put in €1,000 to meet this goal. Before the second quarter, the value of your investment increased to €1,100. This is too much, so in the next quarter, you would only put in €900 to meet your target of €2,000 after two quarters. After the second quarter, your portfolio dropped to €1,900. Now, you need to put in €1,100 to meet your Q3 target of €3,000. As you can see in this example, when your investment portfolio’s value falls, you put in more money to buy shares, and when it grows, you put in less.
Benefits of value averaging
Value averaging has the potential to outperform dollar-cost averaging over the long term because it takes advantage of market corrections. When the market falls, you’re buying more shares at a lower price, which will increase your returns when the market recovers. Edleson’s book on value averaging is worth reading because it shows that value averaging can outperform dollar-cost averaging.
Another benefit of value averaging is that it can help to discipline investors. By investing more when the market is down and less when the market is up, investors are forced to buy low and sell high, which is the goal of any investor.
Drawbacks of value averaging
Value averaging does have some potential drawbacks. First, it can be time-consuming to calculate how much to invest each month. The benefit of the more simple dollar-cost averaging strategy is that it’s passive. You just invest the same amount each month, which is much easier and can be automated on many investment platforms.
Second, suppose the value drops below your target goal for a period. In that case, you need to increase your monthly investment amount, sometimes quite significantly, to get back on track. This can be difficult for some investors if they don’t have extra cash on hand. With dollar-cost averaging, it’s easy to know how much of your salary or paycheck you need to set aside each month.
Home-bias investing is a phenomenon where investors overweight investments in their home country. For example, most American investors have a portfolio that is 100% US stocks and 0% foreign stocks, even though the global stock market is made up of more than just the US. Similarly, 99% of Brazilian investors keep their portfolio in Brazilian assets, although Brazil only makes up 1% of the global capital market.
We’ve seen how the United States has dominated the world stock market for the previous decade or so. If you were an American investor, your investments would have done extremely well if you had invested solely in US stocks. However, history tells us that performance leadership shifts from region to region over time. The run-up in US equities over the decade from 2010 to 2019 is not without precedence. From 1980 to 1989, Japan was the leading global stock market. From 2000 to 2009, stocks from outside of the US led.
By having a globally diversified portfolio, you don’t have to worry about which region or country is going to lead the pack in any given period. You can pick a global stock index like the FTSE All-World or MSCI ACWI, which includes stocks from around 50 developed and emerging markets. You’ll be diversified across geographies, so you’ll participate in the global market growth, no matter where it comes from. This is why global diversification is seen as the polar opposite of home-bias investing. It’s a diversification technique that moves your assets beyond the performance of your home market or any other market you happen to believe in.
Benefits of global diversification
The main benefit of global diversification is that it reduces your portfolio’s concentration risk. By investing in medium and large caps from multiple countries and regions, you’re less likely to experience the devastating effects of a bear market in any one country. For example, if there’s a market crisis in Europe, your US investments may still do well. Similarly, suppose there’s a deep downturn in US equities. In that case, it’s not unlikely that another country or group of countries will take over the global leadership role, and your portfolio will benefit from that.
In practice, it’s difficult to avoid home bias. The money in your bank account, your house, automobile, and any other possessions you own are all probably located in your home country. But a global ETF can help balance the risk in your portfolio, even if it isn’t a perfect home-foreign allocation. If we look at what has happened in the past, it seems that the strong performance of American stocks is very similar to the excitement experienced in Japan during the 1980s.
Drawbacks of global diversification
The main drawback of global diversification is that it can lead to underperformance during periods when a country is a global leader. For example, if you had a portfolio that was diversified across the globe in 2000, you would have underperformed the US stock market by a large margin for many years.
Another potential worry is political instability. If you invest in global stock index ETFs, they will include emerging markets and, in some cases, frontier markets. These countries tend to be more volatile and risky than developed markets. They also have less transparent financial systems and less effective rule of law, which can lead to political risk and instability. So, if you’re diversified globally, you’re taking on the risk of investing in these transitioning economies.
Sinning with single stocks
Good investing is boring. That’s the mantra of index investors. And it’s true to a large extent. But there’s no reason you can’t have a little fun with your investments and still be a boring, index-hugging investor. While most humans are terrible at picking stocks, the idea of traditional shareholding deserves praise. You’re taking a risk on a company you believe in and think will do well. And let’s face it, index investing with ETFs is robotic and a little bit soulless.
You can still make bets on companies you believe in as an ETF investor. But if you’re going to sin, do it with a small portion of your portfolio. For example, you can invest a percentage or fixed amount of money in a few individual stocks. This way, you can have the best of both worlds. Most of your portfolio will be in low-cost, diversified ETFs. But you will also have a small portion that allows you to take a chance on stocks you believe in.
Benefits of single stocks
Stock picking is fun. It is more exciting to invest in a company when you’re passionate about it or have knowledge about the industry. Following its ups and downs throughout the years can be satisfying. If it’s a publicly-traded company, you can participate in its success by owning a piece of it. You’ll also have voting rights as a shareholder, which gives you some say in how the company is run.
Statistically, you’re making a bad decision by going off-road, but with a small portion of your portfolio, any negative impact on your overall returns will be minimal. And if you do it right, you can make some great profits.
Drawbacks of single stocks
The main drawback of stock picking is that it’s very difficult to do well. Studies have shown that even professional investors who spend their days analyzing companies struggle to outperform the market. Some get lucky for a few years, but in the majority of cases, a diversified index portfolio will outperform even the best stock pickers over time.
Another potential problem is that you can get emotionally attached to your investments. This can lead to bad decision-making, as you might hold on to a losing horse for too long or find it hard to sell when it’s time to take profits.
If your stock is racing ahead, it can also be hard to be satisfied with the modest returns of a diversified index portfolio. Suddenly, you forget all about the studies and analyses that show how difficult it is to beat the market. You convince yourself that you’ve found the holy grail of investing. Remember, even if you have beaten the market in the past, there’s no guarantee you will continue to do so in the future.
Income generation with bond ETFs
Younger investors have time on their side and can afford to take on more risk in pursuit of higher returns. This is typically done with a stock-based ETF. But as you get older, you’ll want to start reducing risk and think about ways to make a stable income from your investments. And one way to do this is with bond ETFs.
Bonds are often seen as boring, but they can be a stable way to generate income. The interest payments (or coupons) are usually fixed, so you know exactly how much income you’ll receive. And if you hold the bonds until they mature, you’ll get your original investment back. Bonds make it easier to calculate how much income you’ll receive, making them ideal for retirees who need to know exactly how much they can expect each month.
Bond ETFs will hold many different bonds. While individual bonds typically pay out interest every six months, bond ETFs make payments more frequently, usually every month. A bond index like the FTSE World Government Bond Index covers investment-grade government bonds with various maturity dates from over 20 countries.
Benefits of bond ETFs
Bond ETFs offer a stable and predictable income stream, which may be suitable for retirees who need to know exactly how much money they will have each month. The payments are usually made monthly, so you don’t have to wait six months for the interest payments.
Another advantage of bond ETFs is that they offer diversification. By holding a basket of different bonds, you can spread out your risk and avoid putting all your eggs in one basket. This is especially important with bonds, as even small changes in interest rates can have a big impact on the price of individual bonds.
Bond ETFs are also easier to manage than individual bonds. You can buy and sell them anytime as there is usually no penalty for exiting them early. Furthermore, you don’t have to worry about maturity dates, coupons, or interest payments from multiple different. A good bond ETF will automatically take care of all of that for you.
Drawbacks of bond ETFs
The main disadvantage of bond ETFs is that they offer relatively low returns compared to other investment options. Aside from that, bond ETFs also charge an ongoing management fee as other index-based ETFs do. If the management fee is too high, it can turn the minuscule returns of a bond ETF into something even smaller.
The second disadvantage of bond ETFs is that they are still subject to the interest rate risk of the underlying bonds. If interest rates rise, the prices of bonds will fall, and your bond ETF will lose value. As the yield on newly issued bonds will be higher than the coupon payments of your existing bonds, there will be less demand for your bonds, and their prices can fall. This is why it can be a good idea to choose an ETF that has a mix of different types of bonds with different maturity dates.
Tax-loss harvesting is a strategy used to offset capital gains with capital losses. You can lower your overall tax bill by selling losing positions and using the losses to offset gains. It’s important to say that tax-loss harvesting doesn’t work the same way in every country. Tax rules vary significantly from jurisdiction to jurisdiction, so make sure to check with a tax professional in your country to see what rules apply to you.
To take advantage of this strategy, you need to keep track of your gains and losses throughout the year. There is software that can do this, but a spreadsheet will also work. You can then sell any losing positions at the end of the year and use the losses to offset your gains. You can also carry forward the losses to offset gains in future years. In the UK, for example, you can use a capital loss to lower your taxes on any capital gains you make in the same year. If you have an unused capital loss, this can be used to reduce any gains you make in future years.
Harvesting losses can be a great way to lower your overall tax bill, especially when the markets are down but you expect them to rebound in the future. That being said, it’s not an easy strategy to implement for beginners, as it requires a bit of work to keep track of all your gains and losses within the context of your country’s tax laws.
ETF strategies: The bottom line
These are just a few of the many ETF investment strategies available to beginner investors. Dollar-cost averaging and international diversification are often considered the simplest and most effective ETF strategies, while tax-loss harvesting can be a great way to lower your overall tax bill. Do some research and find the strategy that best suits your needs and risk tolerance. With a little patience and discipline, you can be well on your way to achieving your financial goals.
The author held positions in ETFs tracking MSCI’s developed and developing indexes at the time of publication.