Posted on September 9th, 2023
If you're starting your investing journey, you've likely heard acronyms being thrown around and are wondering "What the ETF?" Heck, you might even be invested in one, or a few, without knowing what they are. Let’s change that!
To understand ETFs you need to understand diversification. Think of a picnic basket; you don’t just pack a PB&J. Baskets are filled with a variety of snacks, sandwiches and drinks to help minimize the risk of becoming too hungry, too thirsty, and to make sure the day isn’t ruined when something you’re eating inevitably falls on the ground.
A diversified portfolio is essentially a well-planned picnic basket of stocks. That way if one stock has a bad day, you have another stock having a good day to balance things out. The more variety in your basket, the less you’ll be affected by the ups and downs of the stock market.
An ETF, or Exchange-Traded Fund, is a type of investment fund that trades on the stock exchange, similar to individual stocks. It is a way to pool together your money to purchase a share in a fund that can include a variety of assets such as stocks, bonds, or commodities. These funds offer more diversity than purchasing individual stocks.
ETFs can be made up of a variety of assets and are designed to track the performance of a specific index, sector, or asset class. For example, an ETF might track the performance of the 500 of the largest companies listed on stock exchanges in the United States, which is known as the S&P 500 index. By investing in this fund, you are essentially buying a small piece of each of those 500 companies. So, if the overall value of the S&P 500 index goes up, your investment value should increase proportionately. Similarly, if the index goes down, your investment value would likely go down as well.
ETFs are often passively managed. This means that their goal is to achieve a similar return to the market index they track, without trying to beat or outperform it. This hands-off approach aims to capture the overall performance of the market rather than trading in and out, actively trying to select winning stocks. This approach is always the best option for long-term investments, because as the adage says: “Time in the market always beats timing the market.”
ETFs, particularly those that track the total stock market, regularly result in higher returns over time than almost any other investment strategy. With fewer highs and lows than you would experience by trying to pick stocks and time the markets, 9 out of 10 hairdressers report that ETFs result in fewer gray hairs*.
ETFs can, however, get a little bit convoluted, so it's important to look at the prospectus of the ETF, make sure you understand what it's investing in, how it balances itself, what the actual objective of the fund for which you are buying an ETF in, is set up to do. As with any investment, it's wise to do your own homework and not blindly follow every hot tip you hear at the neighborhood barbecue. That being said, in general, ETFs check all the boxes for what we like to see in investments: lower cost, diversified risk, less volatility, and increased liquidity, which is why we're big fans.
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