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When a lot of people think about the financial markets, their mind immediately goes to the Hollywood representation. Perhaps you think of 1970’s stock brokers, peddling stock picks and making loads of cash. Maybe you think of a small group of people making a big bet on something early, and they end up making monster returns. At the very least, you may think of a trading floor with a group of well-dressed savages ruthlessly screaming “BUY BUY BUY” and “SELL SELL SELL”.
That image undoubtedly shapes how a lot of individuals view investing. That image may scare some people away. That image may cause some novice investors to take unjustifiable risks that offer little upside and unlimited downside. Neither of those scenarios sound very appealing. Fortunately, nowadays the financial industry is changing. You will find that even many pros are worried less about stock picking, and more about asset allocation. It is less about trading, and more about investing. Less about what you buy, and more about the proportions in which you buy. Put simply, nowadays, if you brought your money to an adviser they probably wouldn’t pitch you a stock idea, but rather put your money into a handful of funds in a way that conforms to your risk preferences. Those funds are often passive.
Passive investing. Indexing. Buying the market.
These are all buzzwords for the same thing. What exactly do they mean? Why are they so much more popular than the old way of stock picking? How can they make your life easier? We’re going to get into all of that.
And it starts right now!
Passive investing refers to the buying and holding of investments with the intention to own them for a long period of time. Most often, it is partnered with an indexing strategy. That means that instead of picking stocks, you simply buy a handful of funds that capture a large portion of the entire market. We went over all of this when we talked about ETFs, but we’ll summarize some of the key points here:
- An ETF trades on the market like a stock, however, it is an asset that was created by a financial institution that packages together a group of other assets like stocks or bonds. The financial institution creates it and manages it for a fee that is taken out automatically, and you get the benefit of broader exposure in a single trade.
- They can be actively managed and have a fund manager that is constantly looking for the best investments. However, they are almost always passively managed. That means they seek to mimic a certain index which is essentially an entire market. For example, the index that tracks the 500 largest companies in the US is called the S&P 500. Buying an S&P 500 ETF will give you a small piece of every one of those companies. People buy a fund like this for US large-cap stock exposure. Considering US large-cap stocks are very appealing to many investors, and this automatically would give you a huge diversified group of them, some investors feel confident having an ETF like this represent up to 20% or more of their portfolio. The best part? You don’t need to think much at all!
- These indexes can track extremely broad markets, like the global economy, as well as much smaller subsets, like the eSports industry. An index fund that tracks the global stock market may have thousands of different stocks in it. On the other hand, an index fund that tracks the eSports industry may give you exposure to around 50 stocks that operate in that narrow industry. Since that is more narrow, chances are that it could be more volatile and it may be in your best interest to hold less of your wealth in it than you would a broad index fund. Index funds also track everything in between. Their holdings can focus on large stocks, small stocks, foreign stocks, value stocks, stocks in certain sectors, and much more. They also hold bonds. They can track government bonds, high-yield bonds, long-term bonds, international bonds, and much more. A fund investor could create the backbone of their portfolio with broad ETFs, and completely customize it for themselves by picking some more narrow fund. You can still follow a strategy and shift things around to take less risk as you get older.
Now, you may be asking yourself if this is really the way to go. If I just buy everything, won’t I inevitably buy stock in companies that I don’t really like? Or businesses that compete with each other? Or bonds that will default? The answer is yes. Buying these funds will, without question, lead you to purchase certain assets that will underperform. Despite this, they are still popular for a few key reasons:
1. The market is EXTREMELY efficient. Millions of people, and computers, constantly monitor the value of stocks and bonds; buying and selling based on their feelings, predictions, and data. For every buyer, there must be a seller. That means every dollar you make, someone else has to lose, and vice versa. Even professionals get it wrong a lot of the time, and many question if it is even possible to consistently beat the average market return in the long-run. When you buy an index fund, you basically expect an average return. Some things will underperform, some will outperform, and you will end up right in the middle. Rather than spending a lot of time trying to pick what will outperform, it can be a better use of your time to choose a handful of funds that meet your preferences and simply park your money in them. You could truly get it started in minutes, and overtime you may outperform people that devote their lives to stock-picking.
2. These ETFs are cheap and easy to use. Purchasing a fund gives you automatic diversification in as little as one trade, and their fees can be as low as .03% per year. That means that for every $10,000 you have invested, you will pay the investment company that put the fund together three dollars each year. Parked a million dollars in their funds? Pay them as little as $300 per year. Not only do they reduce headaches, but they can also be an excellent value.
3. You get your hand in lots of different pots. If you buy a broad ETF, you are buying a piece of the entire economy. An unbelievable amount of the dollars that people spend will go to businesses that you have an interest in. As consumer preferences change, some of your holdings may increase while others decrease. No need to worry about trying to predict which direction things will go. Millions of people rely on these funds to simply give them a piece of the overall economy. As the economy grows, and it pays out profits to shareholders, you benefit.
Taking all of this into account, perhaps the most appealing thing about these funds is you can feel more comfortable buying them all the time, especially when they are broad. Any individual stock, no matter how stable it seems, can be worth zero tomorrow. Tons of companies go bankrupt every year. It is not always appealing to buy a dip in price since the risk is absolute. On the other hand, what if you purchase a fund that owns a small piece of thousands of US stocks? Or 10,000 International stocks? Or 20,000 bonds? What are the odds that every single asset in the group will go to zero? That seems HIGHLY unlikely, and even if it did happen, our problems would probably be much larger than not being able to retire. As long as a single component in one of these funds retains some value, the fund will be worth something and it will have a chance to rise back to its former value and beyond. You can buy these today, tomorrow, a year from now, and 3 decades from now. During the scariest economic times, you can feel pretty confident sticking to your plan and greatly lower average costs by buying low. Leave your stress at the door.
A passive strategy using ETFs can be cheap, easy, quick, tax efficient, convenient, and it can put your mind at ease.
ETFs vs Mutual Funds
You may be familiar with mutual funds, but not ETFs. They sound very similar. What’s the difference?
An ETF and a mutual fund are extremely similar. They are both a fund of assets, bundled together, and sold off in small pieces. The big difference is that an ETF trades directly on a stock exchange with its own ticker symbol. You don’t buy a mutual fund on the stock market, but rather you purchase directly from an investment company. ETFs offer an array of advantages. First, it gives you more control. You can buy and sell at the market price whenever you want throughout the trading day. Also, there are no investment minimums and no upfront fees for getting into the ETF, and those are common for many mutual funds. Finally, ETFs are so efficient that their ongoing management fees tend to be lower than those of comparable mutual funds. For these reasons, ETFs are becoming more and more popular.
That was mostly a review, but we went over a few new points. Let’s move on. The rest of these readings will be all new information, and it is all tailored to help you better understand how to invest passively with ETFs. First, we’ll go over the key data points you should look at when choosing your funds. Next, we’ll talk about how you can build an extraordinarily diversified portfolio in as little as three trades. Finally, we’ll go over some more specific funds that can help you customize your portfolio to the point that it is truly yours.