How to Invest in ETFs for Beginners
Exchange-traded funds are ideal for those just beginning to invest. Here's how to get your portfolio up and running with ETFs.
A decade ago, younger investors would have to wait to accumulate sufficient capital to build an investment portfolio. Today, it's much easier to learn on the fly between smartphone apps and low- or no-cost investment platforms without losing your shirt.
One of the best and simplest ways to build a diversified portfolio is through using exchange-traded funds (ETFs), which give you access to hundreds of stocks in a single fund at very low fees.
But what is an ETF? Exchange-traded funds are similar to mutual funds in that they hold collections of stocks and bonds in a single fund.
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Unlike mutual funds, ETFs are bought and sold on stock exchanges. That means you can trade ETFs anytime the exchange is open. And you can start investing in ETFs even if all you have to invest is $1.
For example, you can own a tiny slice of some of America's largest companies through the Vanguard S&P 500 ETF (VOO), America's largest ETF with $862 billion in assets under management. VOO is so good at covering the bases, many large institutional investors have some of their holdings in this ETF.
How do beginners invest in ETFs? Read on and we'll give you a roadmap to success.
Practice building your ETF portfolio
Before you invest your hard-earned dollars for real, you'd be wise to practice using a simulated trading application. It will help you better understand the entire investment process, from selecting ETFs for your portfolio and allocating a certain percentage or weight in each ETF to deciding how often you might rebalance your portfolio based on your personal investment goals.
Most online brokers provide practice accounts where you can learn about ETF investing without betting any of your actual savings.
For example, even if you don't have a Charles Schwab account, you can sign up for its paperMoney account on its Thinkorswim trading platform. It provides real-time data so you can get to work setting up a practice portfolio of ETFs. Like all new apps, it might take some time upfront to learn the basics of the trading platform.
Another good trading simulator from an online broker is eToro, whose demo accounts allow you to practice ETF investing with $100,000 in virtual funds.
Other trading simulators worth exploring that are provided free by media businesses include the Virtual Stock Exchange from MarketWatch (owned by Dow Jones & Company) and the Stock Market Simulator from Investopedia (owned by IAC Inc.).
If you're new to ETF investing and decide to use a practice portfolio to get comfortable with the process, it's important to establish a set period — say two to three months — for learning the ropes.
Ultimately, however, your greatest learning will come from your actual experiences investing real money over time. Indeed, the rule of compounding means time is your best friend when it comes to any kind of investing, including ETFs.
Keep your ETF investing simple
Now that you've set up your practice account, it's time to consider how broad you want your portfolio to be. For example, do you want it to be 100% equity ETFs, like the VOO? Equity investments provide partial ownership through common stock in public companies.
Or would you also wish to include bond ETFs to see how a more balanced portfolio might work? Bonds, often referred to as fixed-income investments, provide a set amount of interest on the face value of a bond, periodically over the duration of the bond.
Berkshire Hathaway (BRK.B) founder Warren Buffett said in the company's 2013 letter to shareholders that he had instructed the trustee of his wife's inheritance to put 90% of the amount in a low-cost stock index fund and the other 10% in short-term government bonds. This is called a 90/10 fund.
Studies show that this allocation between equities and fixed income holds up quite well in most market downturns. So, if you want to keep it simple, you could go with two ETFs.
A total world stock market ETF such as the Vanguard Total World Stock ETF (VT) gives you exposure to stocks in the U.S. and elsewhere.
A total bond market ETF such as the iShares Core U.S. Aggregate Bond ETF (AGG) tracks the performance of the Bloomberg U.S. Aggregate Bond Index, giving you broad exposure to U.S. investment-grade bonds.
A more elaborate portfolio might include as many as 10 ETFs with six or seven equity funds, including those focused on small and large-cap stocks in the U.S., international equities for exposure to developed and emerging markets overseas and a couple of other possibilities.
The bond portion might include AGG along with two or three other fixed-income ETFs covering more specific investments such as Treasury Inflation-Protected Securities (TIPS), international bonds and high-yield or junk bonds.
That's the beauty of using a practice account. It allows you to experiment as much as you want without costing you a cent.
Opening your ETF account
If you've figured out the ins and outs of ETF investing and feel ready to put real money to work in an ETF portfolio, the next step is to fund your online brokerage account and start investing.
In addition to Charles Schwab and eToro, many other well-known online brokers can help you get started, including E*Trade, Fidelity and Interactive Brokers.
Each of these online brokers provides fractional share investing. So if you only have $100 to start, you could still buy 10 ETFs for your portfolio. And you can set a specific weighting or dollar allocation for each of them.
If you're new to ETF investing, it's important to understand the costs involved. While many online brokers provide commission-free trading, you'll want to confirm how much it costs, if anything, for each buy or sell transaction.
Additional considerations include account minimums and fees to transfer your account to another financial institution should that need arise. Also, check to see what research is provided, and at what cost. Many online brokers provide it for free.
The other cost to be aware of are the fees charged by the ETFs themselves for managing the funds.
The VOO charges an annual operating expense of 0.03% of the fund's net assets. So, you'll pay $0.30 for every $1,000 invested in the ETF. That fee is deducted from the fund's income, not from your brokerage account.
Investing in your first ETFs
If you're worried it's too late for you to open your first brokerage account, consider this:
Most financial experts recommend you start investing as soon as possible. The longer you're in the market with a well-diversified portfolio, the greater you eventual gains will be.
The critical thing to remember is it's not how much you invest but how early you invest. A little each year over 40 or 50 years adds up.
If you're a beginner, take your time and learn the basics before getting involved with more complex investment instruments such as options.
As Warren Buffett rightly suggests, you can succeed by buying and holding just two low-cost ETFs.
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