If you’re a beginner investor, there’s a good chance you’ve been inundated with investment advice from friends, family members, and random strangers on the internet that probably sounds something like this: “just buy index funds”, “low-cost ETFs are the way to go!” All this well-intentioned advice likely has you thinking, “Great, but how do I actually do that?”. What if you don’t know the first thing about ETFs?
Investing in ETFs can seem complicated, but it’s much easier when you break it down into smaller steps. Investing in ETFs only requires a brokerage account and a few clicks. Here’s a simple explanation for beginners on how to invest in ETFs—including how to buy them and what to watch out for.
What are ETFs and how do they work?
ETFs are investment funds that hold a diversified portfolio of assets on your behalf, such as stocks, bonds, or commodities. An ETF is something you buy and sell on a stock exchange, and its price goes up or down in value depending on the price changes in the underlying asset. The beauty of an ETF is that it packs together a bunch of different investments into one, so you don’t have to go out and buy each individual asset yourself.
For example, imagine you want to invest in the world’s largest companies. You could buy shares in each company individually. But if you don’t have enough money to do that, or you don’t want to spend the time researching each company, you could instead buy an ETF that does it for you.
The ETF would hold shares in each company you’re interested in, and you would own a tiny fraction of each company. When the companies do well and their share prices rise, the ETF’s value also increases, and you make money. Similarly, if the companies have a terrible year and their share prices fall, the ETF’s value falls too, and you lose money.
How to invest in ETFs
Buying ETFs is pretty much the same as buying any other stock. ETFs trade like stocks, so you can buy or sell them whenever the market is open. Here’s how beginners can buy ETFs in three simple steps:
Step 1: Pick an online broker
An online broker is a platform that allows you to buy and sell investments, including ETFs and stocks. When choosing a broker, make sure to compare fees, account minimums, and the types of investments they offer.
Investing through your bank may be your first instinct, but banks typically have much higher fees than online brokerages. Plus, many banks try to push their own investment products, which are usually more expensive and often do not perform very well.
The benefits of using an online broker to invest in ETFs are that you can often do so with minimal or no fees, have access to a wide variety of ETFs and other funds, and invest globally in markets that may be otherwise inaccessible.
Step 2: Find your ETF
Once you have chosen a broker, it’s time to find the right ETF for your portfolio. There are hundreds, if not thousands, of ETFs to choose from, but many people have discovered the advantages of index-based ETFs over the alternatives. You can use the research tools offered by iShares (BlackRock) and Vanguard as a starting point.
Historically, the S&P 500 index has been the most popular index to buy into, as it is made up of 500 of the largest U.S. companies. The US stock market has outperformed most other markets for many years, so it’s only natural that this would be a popular choice.
As the saying goes, past performance does not necessarily predict future results. That’s why another group of ETF investors prefer international index-based ETFs. These funds offer diversification away from the U.S. stock market and can potentially protect against a downturn in the U.S. markets.
Popular ETF examples
Let’s look at a few examples of well-known stock indexes that investors worldwide use ETFs to invest in. The naming conventions for these aren’t objectively speaking very accurate. For example, the MSCI World Index clearly doesn’t cover the entire world, and the U.S. “total stock market index” is not representative of the whole stock market. That’s just something to keep that in mind as you go through this list.
- The U.S. indexes: Total stock market indexes and the S&P 500 Index are two of the most popular indexes to use ETFs to invest in the U.S. stock market. The S&P 500 Index includes only large-cap stocks. Funds named “total stock market index” usually have between 3,000 to 4,000 small-, mid-, and large-cap stocks.
- The developed world indexes: While U.S. stocks have performed better than ex-US for a long time, the opposite has been true before. That’s where “developed world” indexes come in. These include equities from North America, Europe, Australasia, Japan, and Singapore. The popular ones are the MSCI World and the FTSE Developed World.
- The global indexes: If you want to go even further afield, there are “global” or “all world” indexes that include stocks from both developed and emerging markets. The FTSE All-World, FTSE Global All Cap Index, and MSCI ACWI are three well-established examples.
- Emerging markets indexes: Finally, we have indexes that focus on stocks from the “emerging markets.” Some of the most established ones are the FTSE Emerging Markets, MSCI Emerging Markets Index, and S&P Emerging BMI Index.
Of course, this is just scratching the surface. There are many other indexes worth researching, including ones that focus on specific countries (e.g., “Japan” or “China”), regions (“Latin America”, “Europe”, etc.), sectors (“technology”, “healthcare”, etc.), or even investment strategies (e.g., “low volatility”).
For inspiration, here are the largest ETFs in the world in Europe and the U.S. Both regions prefer investing in the U.S. stock market, but Europeans are clearly more willing to diversify into other regions, as showcased by their interest in the MSCI World Index:
Step 3: Buy and hold the ETF
Once you have chosen your ETF, it’s time to actually buy it. You do so by transferring money from your bank account to your brokerage account and then placing a buy order for the ETF.
Many brokerages let you set up monthly or weekly recurring orders. These automated orders can be helpful if you want to dollar-cost average into a specific ETF or set of ETFs. You can instruct your bank to automatically transfer a fixed sum of money to your brokerage account on the same day each month. This way, you can invest in your favourite ETFs without having to think about it.
Most ETFs are not meant for short-term speculation but are rather long-term investments. ETFs, no matter the underlying index or asset class, will have volatility (go up and down in price) in the short term. Of course, there are no guarantees, but the stock market has always recovered from setbacks in the past and continued to new heights.
Can I buy an ETF on my own?
With the advent of online brokerages, buying an ETF is now easier than ever. You can open an account with a brokerage firm and buy ETFs just like you would buy any other stock. But should you use a financial advisor or let someone else manage your ETF investments?
It all comes down to how comfortable you are with investing on your own and how much experience you have. Buying and managing your ETFs through an online broker is undoubtedly the most cost-effective way to do so. If you’re not sure where to begin or how to build a portfolio for your objectives, professional assistance may be worth the extra cost.
Benefits of investing in ETFs
The main benefit of investing in ETFs is that they offer a simple and efficient way to invest in multiple assets at once. For example, an ETF tracking stocks from the developed world gives you exposure to thousands of stocks across dozens of countries with a single trade.
Because ETFs are packages of assets, they offer diversification, which is an important risk management tool. By owning a few different ETFs, you can spread your investment across several asset classes, indexes, countries, sectors, etc.
Another benefit of ETFs is that they are cheap to buy and own. The fees charged by ETF providers (the “expense ratio”) are much lower than the fees charged by traditional actively managed mutual funds. Furthermore, more and more brokerages offer commission-free trading for ETFs. This means you can buy and sell ETFs without paying a commission.
Drawbacks of investing in ETFs
The drawbacks of ETFs are not often discussed, but there are a few things to be aware of.
First, ETFs are not without risk. Like any other investment, the value of an ETF can go up or down. In fact, because ETFs often track broad indexes, they will usually rise and fall with the market. More risky ETFs, like inverse or leveraged ETFs, can magnify these movements and are often unsuitable for beginners.
The main problem with ETFs is that they are owned by mega-corporations such as BlackRock, Vanguard, and State Street. These fund managers have clearly benefited investors — their passive-investing index funds have lowered costs and boosted returns for millions of individuals. But their rise has come at the expense of intense concentration in corporate ownership. In the future, a few companies could have an oligopolistic level of control over the world’s stock markets.
The different types of ETFs
Now that we’ve covered the basics of buying ETFs, let’s look at the available types available. The most popular ones are index funds, sector funds, and commodity funds.
- Index-based ETFs: Index funds track a specific market index, such as the S&P 500 or the MSCI Emerging Markets Index. These ETFs give you exposure to all (or a representative sample) of the stocks in the underlying index.
- Sector ETFs: Sector funds invest in a specific sector of the economy, such as healthcare or technology. These ETFs can be a good way to target industries that you are bullish on or have insider knowledge about.
- Commodity ETFs: Commodity funds invest in a specific commodity, such as gold or oil. These ETFs can be a good way to hedge against inflation or diversify your portfolio.
- Inverse ETFs: Inverse ETFs are designed to profit from a decline in the underlying asset. They offer a way to short the market or hedge your portfolio against a downturn.
- Leveraged ETFs: Leveraged ETFs are designed to magnify the returns of the underlying asset. They are a way to make higher-risk, higher-reward bets on the market.
Index-based ETFs are usually recommended for investors of all experience levels because they offer broad market exposure and are less risky than other types of ETFs. However, there is no one-size-fits-all answer, and more advanced investors often build portfolios with a mix of different ETFs.
Tips for choosing the right ETF
Now that you know the different types of ETFs available, here are a few tips for choosing the right ones for your portfolio:
- Consider your investment goals: What are you looking to achieve? Are you trying to beat the market or simply match it?
- Consider your time horizon: How long do you plan on holding the ETFs? Will you need the liquidity to cash out quickly, or can you afford to wait for the markets to rebound?
- Consider your risk tolerance: How much volatility are you willing to stomach? Can your mental health endure the inevitable ups and downs of the markets, or do you need to stick with less volatile investments?
- Consider your portfolio: What other investments do you already hold? Maybe fixing and selling properties are better for you if you have the know-how, or perhaps you want to keep it simple with a target-date retirement fund.
- Do your research: Be sure to read the ETF’s prospectus before investing. This will give you a good idea of the ETF’s investment strategy, fees, and risks.
When choosing the right ETFs for your portfolio, there is no one-size-fits-all answer. The best way to find the right ETFs is to consider your investment goals, time horizon, risk tolerance, and portfolio composition. And, of course, don’t forget to do your research.
How to sell ETFs
Selling an ETF is as easy as buying one. Just place a sell order with your broker, and the ETF will be sold at the next available market price.
If you need to sell an ETF quickly, you can place a market order. This ensures that the ETF will be sold at a specific price, even if it takes time to find a buyer.
If you want to sell an ETF at a specific price and you’re willing to wait for a buyer, you can place a limit order or stop-loss order. This type of order becomes a market order when the ETF reaches your specified price.
Remember the tax implications when selling. Depending on the rules in your country, you may have to pay capital gains tax on any profits.
Is investing in ETFs a good idea?
The answer to this question depends on your investment goals and risk tolerance. ETFs offer many benefits, such as diversification, low costs, and commission-free trading. However, they also come with some risks, such as market risk and concentration risk. Ultimately, whether or not investing in ETFs is a good idea for you depends on your individual circumstances.
What are the risks of investing in ETFs?
The main risks associated with investing in ETFs are market risk and concentration risk. Market risk is the risk that the value of an ETF will go down when the market goes down. Concentration risk is the risk that a small number of companies will have too much control over the companies in the ETF.
Are ETFs good for beginners?
Yes, ETFs can be a good investment for beginners. Index ETFs can offer excellent diversification at very low costs. Index-based ETFs are usually recommended for investors of all experience levels because they provide broad market exposure and are less risky than other types of ETFs.
Do ETFs pay dividends?
Many ETFs come in two variants: dividend-paying and non-dividend paying. Dividend-paying ETFs distribute the dividends they receive from the underlying stocks to shareholders. Non-dividend paying ETFs reinvest the dividends they receive from the underlying stocks back into the fund. Depending on the tax rules in your country, one may be more beneficial than the other.
Are ETFs riskier than stocks?
No, index ETFs and bonds ETFs are regarded as less risky than stocks. This is because they have multiple holdings and are not subject to the same level of volatility as individual stocks. For example, if you only own ten different stocks and one of those takes a massive nosedive, your entire portfolio will take a hit. However, if you own an index ETF that tracks thousands of stocks, the impact of any one stock on your portfolio will be much smaller. On the other hand, ETFs can never mirror the upside of their best-performing stocks.
Can you lose money in an ETF?
Yes, you can lose money in an ETF. They are not well-suited as short-term investments and can be subject to market volatility with long periods of no growth. This is why professionals frequently recommend diversifying your portfolio across international markets to avoid being dragged down by a single economy.
At the time of publication, the author held positions in MSCI ACWI and MSCI World ETFs.