Exchange Traded Funds: An Easy First Step Into the Stock Market

exchange traded funds

According to a survey conducted by Ally Invest, 61 percent of adults say they find the idea of investing in the stock market “scary or intimidating.” Millennials were far more likely than their older counterparts to report feeling intimidated. And it’s not only fear and a lack of understanding holding millennials back from buying stocks, as high student loans balances also make it harder for millennials to get their money into the market.

Unfortunately, not investing in stocks often means missing out on the best chance to grow your wealth, as Barrons indicates stock market growth outpaces real estate price growth.

Fortunately, you don’t have to know a ton about the market, or be worth a fortune, to begin acquiring ownership in stocks if you invest in exchange-traded funds, or ETFs.

“ETFs could be attractive for young people since you do not need a lot of money to begin investing and their costs are low,” said Douglas A. Boneparth, certified financial planner and president of Bone Fide Wealth, LLC.

To decide if ETF investing could be a good option for you, read on to learn what ETFs are, how they work, and why you might want to buy them.

What are exchange-traded funds?

Exchange-traded funds are investments you can buy on a stock exchange. A stock exchange is a marketplace where securities — or financial products with monetary value — are sold.

If you buy a share of Apple’s company, for example, you buy that share on an American stock exchange called the NASDAQ. The New York Stock Exchange (NYSE) is another stock exchange used by traders to exchange shares of securities.

ETFs are a special kind of security. Instead of buying shares of individual companies — which can be risky if something goes wrong with that business — you buy into a fund that owns multiple different assets.

“ETFs are a pool of investments,” Boneparth explained. Money is pooled together and used to buy company stock shares or bonds. When you’ve purchased an exchange-traded fund, you indirectly own a very small amount of every asset the ETF owns. For example, if an ETF used its pooled money to buy shares of technology companies and you bought that ETF, you’d indirectly acquire fractional shares in technology companies such as Apple, Dell, Microsoft, and more.

ETFs trade just like any other stock. Each fund is sold on a stock exchange and has a price at which you can purchase it. You put in an order to buy an ETF using a brokerage firm. You can buy as many or as few ownership shares in the ETF as you want.

ETFs are priced based on what traders think they’re worth which is close to the net asset value — the combined value of all the investments the fund owns. Owners of shares of the ETF ask a certain price for their shares, and potential buyers make a bid. When the bid and ask match, the current owner of the ETF sells to the bidder. This all happens electronically.

How does ETF investing work?

Because exchange-traded funds own different kinds of assets, you can diversify your entire portfolio by buying different kinds.

As Fidelity explains, ETFs can give you exposure to stocks, bonds, gold, commodities, emerging stock markets, or real estate. You could buy an ETF that’s designed to track or follow the performance of a particular part of the stock market. For example, you could buy an ETF designed to track the price of gold, the performance of the bond market, the value of the real estate market, or the price of oil.

One popular option is to buy ETFs that track stock indexes to gain broad exposure to stocks. Stock indexes such as the S&P 500 or the Dow Jones Industrial Average (DJIA) are representative samples of securities designed to mimic the overall performance of parts of the stock market. The DJIA is a market index that tracks the performance of 30 of the biggest U.S. companies. An ETF intended to track the DJIA would use its pooled money to buy stock shares of the 30 companies that make up this index.

You want to diversify — own different kinds of assets — because if one part of the economy isn’t performing well and some of your investments are going down, another part of the economy will hopefully be doing better.

What are the pros and cons of investing in ETFs?

There are advantages and disadvantages to buying ETFs you’ll need to consider when deciding if this investment is right for you.

Pros of investing in exchange-traded funds

“On the pro side, they trade like stocks, which means you can get in and out of the market quickly,” Boneparth said. Because you can buy or sell shares of ETFs on a stock exchange, it is easy to purchase them and you can sell immediately if you need to — unlike with a real estate investment, which may be expensive and time-consuming to sell.

Another big benefit, according to Boneparth: You don’t need a lot of capital to start investing in ETFs. This is opposed to mutual funds, another type of investment that allows you to buy into a big pool of diverse assets. Many mutual funds require you to make a large initial investment, which can put them out of reach of beginning investors.

Many ETFs also have a very low expense ratio. As the Wall Street Journal explains, an expense ratio is taken from your account to pay the annual expenses for the fund you are invested in. The average ETF has an expense ratio of just 0.44 percent, compared with a 0.74 percent expense ratio for a traditional index fund. With a 0.44 percent expense ratio, you’d pay just $4.40 for each $1,000 invested. A lower expense ratio means you keep more of your money.

Cons of investing in exchange-traded funds

While ETFs typically have a low expense ratio, this is not necessarily the only cost you’d have to pay to invest.

“There could be commissions to trade,” Boneparth said. If you want to start small and buy only a few shares to build up your investment over time, the commission you pay each time could eat away at your profits.

The good news is, there are options to avoid transaction costs through the purchase of commission-free ETFs sold through financial service providers such as Fidelity. When an ETF is commission-free, you do not pay the fees to buy or sell, but the expense ratio still applies.

Should you invest in exchange-traded funds?

In 2016, there was more than $2.5 trillion invested in ETFs. Adding your money to this big pot could be a simple way to start gaining exposure to different kinds of assets so you can build a diversified portfolio.

It’s important to keep in mind that there’s always some risk to investing. If you buy an ETF that owns a particular class of assets, such as bonds, and those assets decline in value, you could lose money. Some financial experts believe ETFs may not perform the way most investors expect them to, even though many experts believe ETF investing is relatively safe when done correctly.

The bottom line: You should never invest in anything you don’t understand. So, before you decide if ETF investing is right for you, understand what kind of assets the ETF owns and what the risks are.

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