Quick note: This post is about ETFs, but before we get to that, I go on for a while to introduce some important concepts in investing. If you’re new to this, you might hopefully find it interesting and useful.
Alternatively, you can skip down to the section titled “A Primer on Exchange Traded Funds (ETFs)“. Let me know whether you enjoy this post and if you’d like to see more of these!
Let’s Talk About Risk, Bay-bee!
Many people shy away from investing their money because they’ve heard of how it can be very risky. First thing to note, investing is not gambling. Don’t get me wrong, there is a certain element of risk involved, but it’s calculated risk, and can be avoided to a certain extent.
High levels of risk-taking usually comes from not knowing what you’re doing, and taking advice from people who don’t have a solid grasp of how the stock market works. Don’t be like the proverbial Mr. Jones who lost all his money by placing uneducated bets on stocks based on neighbour Sam’s hot tip.
More people spend time painstakingly researching the kind of smartphone they buy than they would on performing the due diligence required when considering the purchase of shares. This exposes them to unnecessary risk, which can be greatly minimised by conducting the research and gaining a sound understanding of the company before making a decision.
Over the course of this series, you’ll find that in the finance world, risk has a slight but important distinction from our usual, everyday concept of risk. In financial parlance, risk is closer in meaning to “fluctuation” than exposure to danger.
The Market is More Predictable Over the Long-Term
One strategy which you can use to minimise risk is long-term investment. In the short-term (a period of five years or less as a rough guide), investments can be very risky as markets are volatile and unpredictable.
I’d like to draw your attention to the graph below (cheeky screenshot from Google), which depicts the movement of the S&P 500 index over the short-term period of a year.
As you can see, the market is quite temperamental and has a number of sharp dips throughout the time-frame. It is quite hard to predict where the market is headed. Compare this to the graph below, which depicts the S&P 500 since its inception.
From the graph above, you can see that although the market is volatile in the short term, over the long term the market always recovers and surpasses it’s previous peak. This makes long-term investment significantly less risky.
The market will generally continue the long-term upward trend as a result of inflation, rising income (especially in developing markets) and the growing population, in addition to other factors.
Think of investment as a long game, and not one in which quick profits are made.
Think of Investing in Terms of Purchasing the Entire Business
This next part ties in nicely with the concept of long-term investment. People who view investing as extremely risky usually think of the stock market as a very complicated lottery ticket. The idea is that you throw a stack of money at a company’s shares and hope that it rises in value. This is speculation, which is very high risk and not the same as investing.
Investing is quite literally the act of purchasing a portion of ownership in a company. Even though you may be starting out very small, it’s important to think of your investments as if you were purchasing the entire company or business.
This makes you ask important questions, such as, “Would I be willing to hold on to this business for at least 10 years?” or “Does this business make enough money to justify the asking price?”.
This will help you make far better decisions, and help you leave your emotions at the door.
I will get into more detail on this concept in a future post, but for now, let’s get back to ETFs.
A Primer on Exchange Traded Funds (ETFs)
Exchange Traded Funds or ETFs are simple to understand and extremely useful, especially to a new investor. Picking individual stocks can be very risky, as companies which seem very strong on paper can all of a sudden be wiped clean off the map (Looking at you, Lehman Brothers).
Applying the 80/20 rule to investing, the easiest and most effective way to start investing is to utilise ETFs, which although limited, can still provide you significantly higher returns compared to parking your money in a bank.
If you are new to investing, but would like to start with something relatively low-risk, ETFs are perfect. But first, what on earth is an ETF?
Think of it this way: If you combine a stock index (like the Dow Jones Industrial Average, the FTSE in London or the ASX 200 in Australia) and a regular stock which you can buy and sell, you would get an ETF.
A stock market index is basically a weighted average of a set number of stocks. For example, the S&P 500 index in the U.S. is the weighted average of the 500 largest companies in the country.
An ETF basically tracks the movement of an underlying security. This just means that whenever the market moves up or down, the ETF follows in the same direction.
An ETF can be thought of as a basket containing a number of securities or shares. Imagine you had $10 with you, and the basket containing the securities you want costs $100. If you shared the total cost with others, you would be able to purchase the basket, and you would have a 10% ownership of all its contents. This is essentially how an ETF works.
I’ve included this YouTube video which does a pretty good job of explaining ETFs. I’m not in any way affiliated with Zions Direct, I just thought it was a helpful video.
Since individual stock picking can be risky, you can avoid the problem by buying the entire market. You could do this either by purchasing shares in every single company, or you could buy an ETF which tracks the market index, which is already an average of all the companies.
The Standard and Poor’s Depository Receipts (SPDR) is one such ETF that tracks the S&P 500 index. Since the ETF tracks the movement of the actual S&P 500, you’ve essentially diversified most of your risk by purchasing shares in all 500 companies. It’s important to note that when you buy an ETF, you don’t actually own shares in any of the companies. The shares that you own are simply the shares of the ETF itself.
The table below shows the average market return per year from 1900s to the present. If you had invested in and ETF which tracks the market, the following would be the returns that you would have received.
The table above can be found on this site.
Notice how for the most part, 10-year periods have provided positive returns. This goes back to the concept of long-term investment. Keep in mind that the actual return would be lower once adjusted for inflation.
If you hop over to YCharts, you can see how the market has been doing annually over the past few years.
Doubling Your Money With ETFs
Considering that the average return (adjust for inflation) is 7% per year, you can expect to double your money roughly every 10 years. Not too shabby, I’d say!
In the upcoming posts, I’ll explain how you can actually start purchasing shares of ETFs and begin your investing journey. Beyond that, I’ll go into detail on individual stock picking, which can beat market returns and also happens to be the reason Warren Buffett became one of the richest people in the world.
If you have any questions about this, just drop them in the comments below or email me using the Contact page and I’ll try my best to help out!