I want to write a quick guide on investing in ETFs. My goal is not to explain every single thing because for most readers, I think this is not needed. I will, however, put links to other sites with explanations, in case anyone wants to look into a specific topic.
Investing in ETFs … Why?
Before I dive into what index fund is, let me explain what is actually the goal here. Most of us know that we should invest part of our paycheck, every month, into stocks or bonds or real estate or whatever. This is because we want to retire sooner, save money for big purchases (like house/apartment), have cash reserves while retired, etc. etc. If we hold money in cash in a bank account, we would lose approximately 2 % of the value of it thanks to inflation. Inflation means stuff costs more with time. A piece of bread today costs 1 €, while next year it will cost 1,02 €. It’s a stupid analogy, but you get the point.
So why should we invest in index funds primarily, and not stocks/bonds/real estate? It’s because we want to invest in the whole world economy. With this we will get:
- Diversification – index funds invest in lots of stocks, so you are not worried if any one of them goes bankrupt.
- Low cost – since you buy only 1 product (index fund), your expenses are bound to only this product. Later, I will explain why even most of these expenses can be avoided.
- Simplicity – same as above, buying 1 product per month is simple and not time-consuming. You don’t have to check prices every day and lose your hair if they go down, because you know that, overall, they go up.
- Safety – essentially, if you follow the steps on how to invest in index funds, the possibility of losing money goes pretty close to zero.
- Other pros which I don’t remember at the moment. 🙂
What is Index Fund?
Let me explain this from top to bottom, as it’s easily understandable (in my humble opinion).
An investment fund is legal entity that collects money from investors and uses it to invest in specific products. These products can be bonds, gold, companies, countries, markets, sectors, etc. Investment fund charges a fee to investors and distributes earning of the fund to said investors.
Investment funds are connected to a so-called index. An index is a benchmark of the overall market or sector. Some of the more known indexes are the S&P 500 and Dow Jones.
Active and Passive Investment Funds
There are 2 types of investment funds in regards to how the investment strategy is applied:
- Active funds – With active funds, it’s investment managers try to outperform the index. They do this by speculating which (sub)markets or sectors are going to yield better results, therefore outperforming the overall market. These funds are actively managed, hence the name active funds.
- Passive (or index) funds – Passive funds investment managers can’t speculate on the market. They simply have to follow the index. So they are passively managed, hence the name passive (or index) funds.
Which to Choose – Active or Passive Funds?
Always choose passive (index) funds. The reason is simple: with active funds, you are promised higher returns for exchange for higher fees. BUT, as it turns out, 80% of active fund managers fail to beat the index, let alone outperform it! (Check here if you want to learn more.)
So the decision is easy – always choose passive (index) funds.
Mutual and Exhange Traded Funds
In regards to its structure, investment funds can also be devided into 2 types:
- Mutual funds – can be bought from the fund company.
- Exchange-Traded Funds (ETF) – can be bought on a stock exchange through a stockbroker. So when you buy on a stock exchange, you are buying it from other investors, just like you.
Which to Choose – Mutual Funds or ETFs?
Always choose ETFs. The reason is simple – you are cutting out the middle man (the fund company) and therefore cutting down your expenses.
So which passive ETFs to invest in?
Here comes the king. His name is 3 Fund Portfolio. Here, we invest in 3 funds:
- US stocks
- US bonds
- International stocks
So, we buy a fund that invests in US stocks, a fund that invests in international stocks, and fund that invests in US bonds.
So why these 3 funds?
- Simplicity – easy to understand, invest, and manage.
- Low cost – they are the least expensive.
- Diversification – 3 Fund Portfolio tracks over 11 000 different stocks while using bonds to lock in those profits (since bonds are less volatile than stocks).
- Easy rebalancing – Generally, the older you are, the higher percentage of bond fund you should have (again, to lock in those profits). A lower number of funds means easier rebalancing.
In part 2 of my Investing in ETFs guide, I am going to explain how to choose the allocation of each fund in 3 Fund Portfolio, and where to buy these funds.