Building a well-diversified investment portfolio may seem out of reach. ETFs could be a good way to kick-start your savings and investment plan. Find out why and how.
One of the greatest advantages young investors have is time. The more time you have, the more the power of compounding can work for you.
But if you're like many other millennials who are just starting out, building a well-diversified investment portfolio may seem out of reach. ETFs could be a good way to kick-start your savings and investment plan.
"ETFs can be a great match for millennials as they offer a simple entry point into the market without needing to save thousands of dollars for an initial investment. They also typically have low fees and offer instant diversification," said Richard Powers, head of ETF Product Management at Vanguard.
Here's why ETFs offer significant benefits for millennials' portfolios:
- ETFs offer a low-cost way to invest
Funds that track an index, whether ETFs or mutual funds, typically cost less and are more tax-efficient than actively managed mutual funds. The savings that come from investing in a low-cost fund can add up and compound into greater wealth over time. Combine that with the advantage of investing early, and the potential for a difference in wealth can be considerable.
One consideration, though, are transaction costs. If unchecked, costs can mean a big difference for an investor’s return over the long-term. So it’s important to compare fund costs before you invest. Look at things like brokerage fees, buy/sell spreads and management costs. These can all add up over time. For example, if you're charged $10 brokerage to make a trade, purchasing 10 ETF units that cost $100 each, totaling to $1000, means your investment will need to rise by 1.0 per cent before you see any gains.
- ETFs have a low hurdle to invest
Depending on the minimum investment defined by your broker, you could buy your first ETF units for as little as $500. Contrast this to mutual funds, which might require an initial investment of several thousand dollars or more. ETFs can make it easier for a newbie investor to get started, and continue building wealth in manageable increments.
Also, it doesn't take much to construct a balanced portfolio. You can put $500 in a stock ETF and $500 in a bond ETF to achieve a diversified two-asset-class portfolio which, though simple, can be a great start toward building a portfolio appropriate for your goals. ETFs can be a simple way to build incrementally toward your long-term plan.
- ETFs can offer instant diversification
Most ETFs are designed to match the performance of the index they track. As long as the ETF strategy is broadly invested across the market, such as a global developed markets index ETF, one single share can provide you with exposure to hundreds, even thousands, of the world’s largest companies.
But not all ETFs provide the same level of diversification; some ETFs offer concentrated exposure in specific market sectors or narrow collections of securities that offer certain traits, like high yield. Such ETFs can benefit a portfolio if they align with its goals, but new investors will likely be best served by starting with more diverse ETFs that tap a wide pool of stocks or bonds.
So before making any investment moves, determine your investment goals and research your ETF options. Make sure you know how many and what kind of securities an ETF holds when determining if it is a suitable fit for your investment goals.
The earlier you start, the less you have to save
This hypothetical example shows just how powerful compounding can be for the early investor. Two people with similar financial goals start investing at different times:
- Dawn starts investing at age 25 and contributes $2,000 each year for 10 years (until she's 35 and has invested $20,000).
- Dave starts investing at age 35 and contributes $2,000 each year for 30 years (until he's 65 and has invested $60,000).
Assuming that their investments earn 8 per cent a year, at age 65, Dawn will have $314,870. Dave will have $244,692. So even though Dave saved more and for a longer period of time, Dawn will have over $70,000 more in her retirement account than Dave. (Sorry, Dave.)
Hypothetical rates of return illustrated in this article are not guaranteed.
So how do you start investing in ETFs?
You'll need a brokerage account (such as Vanguard Personal Investor) to trade ETFs. If you can buy or sell stocks in it, then you can also buy an ETF.
The longer you keep your money invested, the better your odds are of overcoming periods of market decline. This is just one factor among many that lead to long-term investing success.
For more information on Vanguard's principles for investing success, click here.