investments

What Is an ETF?

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ETF

In a previous post, I discussed what a mutual fund is.

Today’s post describes another financial instrument, the ETF. ETF stands for Exchange Traded Fund. An ETF is very much like an index mutual fund, the kind of fund that buys into a market index rather than actively trying to outperform the market.

There is one very important difference, however. A mutual fund cannot be bought and sold on the fly in the way a stock can. With a mutual fund, you put in your order, and the trade is executed at the end of the next trading day. Many mutual funds have other ways of discouraging investors from behaving like traders.

With an ETF, you can behave like a trader. You buy and sell your ETFs just like stocks. For example, in the middle of the day, you hear some bad news and you learn that financial markets have dipped because of the news. You believe that the dip is only very temporary, and you speculate that the markets will return to normal after the dust has settled. You can buy in the morning and sell in the afternoon. Commissions tend to be low, and the internal costs of running an ETF tend to be low as well.

Some people avoid ETFs because they prefer the restricted world of the more boring mutual funds. Perhaps the biggest mistake investors make is to begin to speculate rather than invest. The flexibility of an ETF encourages people to speculate, and some think that’s a flaw.

What Is a Mutual Fund?

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MutualFund

The best thing about a good retirement plan like the one offered to employees of Johns Hopkins University is that we have a large number of ways in which we can invest our retirement money. But sometimes it seems as if that’s also the worst thing about the plan. There are so many choices that it’s sometimes confusing.

The choices usually boil down to choosing mutual funds. Not too long ago, someone told me that he wasn’t exactly sure what a mutual fund was!

A mutual fund pools money together from investors. A professional manager decides to invest that money based on the fund’s objectives. The idea works well for small investors, who may not want to risk buying individual stocks because doing so puts too many eggs in one basket.

For example, an investor might decide to invest in the 500 largest companies in the United States. That investor doesn’t have the money to buy stock in each of those 500 companies. A mutual fund manager uses the pool of money in the mutual fund and buys stock in these companies on behalf of the investors.

There are mutual funds that suit the purposes of almost any investor. For example, Vanguard (like many other investment firms) has a fund called the Vanguard 500 Index Fund that invests in America’s 500 largest companies. Other funds, like Fidelity’s Select Biotechnology Portfolio, buy into specific industry sectors. Other funds might invest in a particular country or region. For example, Fidelity has a Japan Fund and a Europe Fund.

Some mutual funds are designed to enable investors to keep their choices in line with their beliefs and values. For example, TIAA -CREF’s Social Choice Equity Fund favors companies that treat the environment responsibly, serve local communities, make high-quality safe products, and manage ethically.

There are even funds that specialize in “sin” stocks. The USA Mutuals Barrier Fund invests in tobacco, alcohol, weapons, and gambling!

A useful distinction is between index funds and managed funds. An index fund (like the Vanguard 500 Index Fund) buys blindly into America’s 500 largest companies. In contrast, managed funds carefully select stocks or bonds to maximize the returns for their investors. There are advantages to both strategies. Many people believe that it’s better to have a well-diversified portfolio rather than to make bets on particular countries, sectors, or regions. Others think it’s important to be able to take advantage of financial trends. Typically, a managed fund needs more analysts and experts, and the cost of hiring these people is often high. The Vanguard Index 500 Fund, for example, has an expense ratio of 0.17%, while the Turner Medical Sciences Long/Short Investor Fund has a net expense ratio of 2.2%. So you need to manage the risk of your returns being spent on these expenses.

We cannot advise you how to invest your money on this blog, but any financially savvy person will tell you to make sure of two things. First, make sure that a fund’s management costs are not too high. Second, make sure your portfolio is diversified across a broad range of sectors, countries, financial instruments, and strategies.

The biggest mistake investors make is to try to chase the hottest funds in the hope of “beating the market.” A slow, steady, and deliberate approach is the path to financial security. It’s boring, but it works!

 

The Rule of 72

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Money

People who invest often want to know how much money they will have when they actually need it. Unfortunately, it’s hard to calculate that in your head because of the compounding effect when an investment grows.

Someone came up with “The Rule of 72.” This makes it a lot easier. Supposing you are 26 years old. You have bought an investment for $5,000, and you believe its value will increase by 6% every year. You hope to retire when you’re 62 (36 years from now). You’re curious about how much money you can expect to see when you retire.

Here’s where the rule of 72 comes in. You take 72 and divide it by your projected return rate.

72 divided by 6 = 12.

Twelve is the number of years it will take for your investment to double.

So you can expect your money to grow as follows:

Year Age Value
2015 26 $5,000
2027 38 $10,000
2039 50 $20,000
2051 62 $40,000

 

The Rule of 72 is a useful trick to project investment value, but it does have its limitations. First of all, it’s an approximation. Second, it’s next to impossible to predict the performance of any investment. You should be especially wary of using the past to predict the future.

There are several things people should think about as they plan for retirement:

  1. Start early. If our hypothetical investor had waited 12 years to invest that $5,000, he would have wound up with only $20,000.
  2. Don’t try to be too clever. Almost nobody knows how to consistently outperform the markets. Don’t believe anyone who promises fantastic results.
  3. Be aware of your own risk tolerance. The bigger the possible reward, the bigger the risk. Don’t put your money into risky investments if you cannot put up with occasional losses.
  4. Be aware of costs. People saving for retirements typically invest in mutual funds. The managers of these funds need to be paid, but the costs vary very widely. Your money should be working for you rather than supporting someone else!
  5. Diversify. Don’t put all your eggs in one basket. Make sure that you have a mix of funds that match the time you’d like to leave your money to grow and your risk tolerance.
  6. Safe isn’t always safe. If you want to keep your money for a long time, you need to find ways of making it grow. Otherwise, inflation will decrease the value of your savings.

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