If you have started saving money — or are starting to think about it — or are sitting on money you have been afraid to invest — the next question is simple:
What do you actually do with that money?
For many people, this is where things get confusing. You hear terms like:
- Stocks
- Bonds
- Mutual Funds
- Index Funds
- ETFs
You may feel like you need a finance degree just to take that first step. Looking at this list, you will have questions. Certainly one will be — What is an ETF?
You don’t.
If you take nothing else from this post, take this:
An ETF is one of the simplest and most effective ways to get started. It allows you to enter the stock market and instantly diversify your entire investment. I talk about the importance of diversification in The Beginner’s Guide to Building Wealth.
One of my favorite resources for learning about the stock market, Jim Cramer, always says this is where you should put your first $10,000. Don’t worry, if you are not at $10,000. The concept is the same.
What is an ETF?
ETF stands for Exchange Traded Fund.
Simply said, an ETF is a collection of investments that are bundled together into a single fund.
Instead of buying one stock, you are buying a small piece of many investments all at the same time.
Instead of trying to pick one winning stock, which can be very risky, you’re buying a basket that holds many different companies.
Some examples:
- SPY is an ETF that tracks the Standard & Poor’s 500 (S&P 500). Put your money in this ETF and you own a small piece of the largest 500 companies in the United States.
- QQQ is another example and this focuses on the Nasdaq 100. If you watch television and pay attention to commercials, you are sure to have seen commercials for the Invesco QQQ.
These ETFs allow you to invest in the market as a whole versus trying to pick which companies will win. Once you learn more, you certainly can focus on individual stocks but there is always a place for an ETF in your portfolio. I personally try to hold around 20 stocks but I also have some money in ETFs.
Why ETFs Are So Powerful
Most people think investing is about picking the right stocks or timing the market (bad idea as discussed at Trying to Time the Market? Here’s Why That’s a Costly Mistake) or constantly watching prices. Picking the right stocks and doing your homework is certainly important once you start to choose individual stocks but this is not the only way to participate in long-term investing.
ETFs simplify everything and allow you to participate in a group of stocks that historically, over time, increase in value.
Diversification Without Having to Pick Individual Winners
I mentioned this above. Diversification of your portfolio (and your overall net worth) is critical.
When you buy one individual stock, you are betting on one company.
If that company struggles, your investment struggles.
With an ETF, your money is spread across a lot of companies, which greatly reduces the risk. One company will not make or break you.
You don’t need to guess:
- Which stock will outperform?
- Which industry will win?
- When to buy or sell?
Instead of trying to beat the market with one company, you own the market.
ETFs Are Built For Consistency
ETFs are designed for long-term investing.
You do not need to trade constantly, watch the market every day, or react to all the current headlines around the country and the world.
Let me be clear, ultimately it is great to build a portfolio of individual stocks. I try to own around 20 stocks (so they are diversified) but there is also space in my portfolio for ETFs.
Until you educate yourself on the stock market and learn how to evaluate different companies, ETFs are a great place to start. They allow you to avoid the common mistakes people make when they are first starting out.
How Do You Actually Buy an ETF?
You buy an ETF the exact same way you buy a stock. You will need a brokerage account of some sort like Schwab, ETrade or SoFi — or through your retirement IRA or your 401(k) if it allows you to do so.
Just search for the ETF, choose the quantity or dollar amount you want to purchase, and place the order. Just like you would buy 10 shares of Nvidia using the ticker symbol NVDA, you could buy 10 shares of SPY. The difference is your 10 shares of SPY give you ownership in 500 companies.
What Matters Most
What matters more than the actual ETF is getting started, staying consistent, and giving your money time to grow.
The habit you built by saving is the same habit you should use to drive success with investing.
I do agree with Jim Cramer, put your first $10,000 into one or more ETFs and let it grow. Do not consider it a savings account to borrow from but a vehicle to build wealth. I highly recommend setting up an automatic transfer, once your budget allows, to a brokerage account so that you dollar-cost average your ETF purchases until you reach that $10,000 mark.
From here, let time do its thing. Untouched $10,000 by age 30 will turn into $147,000 by age 65 without any more money invested (assuming an average 8% return). Increase the amount saved by age 30 to $30,000 and you will have $443,000 by age 65.
Conclusion
You’ve started saving. It is time to put that money to work.
ETFs provide one of the simplest ways to do that.
You do not have to be an expert.
You do not need a complicated strategy.
Just start and stay consistent and you are on the way to building wealth.
What Comes Next
Now that you understand what an ETF is, the next question is:
What is an index fund?
The difference between an ETF and an index fund is a big point of confusion and understanding the difference can help you make better decisions moving forward.
That is what we will cover next in: Index Funds vs ETFs
