Youve probably heard just how important it is to have a diversified portfolio.
Thats stock market speak for Dont put all your eggs in one basket.
But youd need to invest in a lot of companies toachieve diversity on your own.
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Many investors say youd need a minimum of 25 to 30 stocks.
Where are you supposed to find the time and money to invest in that many companies?
Thats why we love exchange-traded funds, or ETFs.
Buying shares in a single ETF allows you to invest your money in hundreds, even thousands of companies.
What Is an ETF and How Does It Work?
Some ETFs areactively managed, which means that humans are choosing the investments.
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If the S&P 500 is up, youd expect your overall investment to rise as well.
If the S&P 500 has a bad day, so does your investment.
The index is a benchmark.
You want a fund that will perform at the benchmark level or higher.
Well discuss all that in greater detail when we get to Types of ETFs.
When you buy and sell an ETF, its a lot likebuying and selling stocks.
One big advantage of ETFs is that theyre less risky than individual stocks.
If you own stock in a company that goes under, your shares become worthless.
But less risk can also mean less reward.
How Is an ETF Like a Mutual Fund?
Still wondering what is an ETF, really?
Youve heard of mutual funds, right?
Well, ETFs are similar tomutual fundsin that both bundle lots of assets into a single investment.
However, mutual funds arent traded on the stock market.
Thats why mutual funds usually have higher fees than ETFs.
Think the human oversight is worth the extra cost?
Countless studies have found that most investment managers underperform compared with market indexes over the long haul.
Another advantage of ETFs is that you could start investing for whatever it costs to buy a single share.
Mutual funds often require an upfront investment of anywhere from $1,000 to $2,500.
Types of ETFs
Lets delve a little more into all the ETFs there are out there.
As of 2019, there were2,096 exchange-traded funds and they arent just limited to stocks.
Those with the broadest exposure are usually called total market funds.
These focus on specific industries within the overall market.
For example, you could invest in a health care or energy ETF.
In general,investing in bondsis a good strategy for people who need fixed income, like retirees.
How Are ETFs Taxed?
Youre taxed on ETF gains only when you sell your shares at a profit.
At that point, youre taxed the same way the underlying assets are taxed.
But if you really want to max out those gains, owning ETFs in aRoth IRAis a great option.
Are ETFs a Good Investment?
Here Are the Pros and Cons
So are exchanged-traded funds a good investment?
The answer boils down to what the ETF is invested in.
But generally speaking, lets recap some advantages and disadvantages of ETFs.
ETF Pros
ETF Cons
How Do I Start Investing in ETFs?
Ready to start investing in ETFs?
Well, you may already be an ETF investor and not even know it.
If you want to pick your own ETFs, the best way to start is byopening a brokerage account.
Here are a few things to look at when you make your pick.
Historically, the stock market has averaged returns of 10% per year before inflation.
By investing in the broader stock market, you could take advantage of this long-term growth.
Youll do so in exactly the same way you would when you place an order for a stock.
If you trade through a human broker, youll notify them and provide the information.
Or you’re able to use a buy limit order.
Once youve decided to invest in ETFs, set yourself up for long-term success by practicing dollar-cost averaging.
The easiest way to do this is to budget a certain amount to invest each month.
That protects you against buying too many assets while prices are high.
A final tip: Ignore the day-to-day performance of your ETFs.
Your goal is long-term growth, not a short-term profit.
ETFs arent risk-free, so dont invest money in them that youll need in the next few years.
Robin Hartill is a certified financial planner and a senior editor at The Penny Hoarder.
She writes the Dear Penny personal finance advice column.
Send your tricky money questions to[email protected].
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