Investing can be as simple or as complicated as you want it to be, depending on how much time you wish to devote to it. Here at the Motley Fool, we enjoy scrutinising company reports and commenting on the best (and worst) businesses out there with the intention of helping shareholders maximise their returns. If you're new to investing however, all this can feel a bit 'too much, too soon'. So let's look at another hugely popular option for private investors: Exchange Traded Funds (ETFs).
Diversification on the cheap
ETFs are simple to understand. In an industry where marketing gurus have a habit of making the ordinary look extraordinary, that's no bad thing. ETFs track an index, a commodity, bonds, or a group of companies linked by a common theme. Like index trackers, their passive nature means charges are often a lot less than those for actively managed funds. Unlike index trackers however, they can be traded throughout the day, just like a normal share.
A major positive is that they provide instant diversification. An ETF that tracks the FTSE 100, for example, will buy slices of all the companies in that index, usually in proportion to their market capitalisation. In practice, this means that you'll be more invested in the biggest companies (like Royal DutchShell, GlaxoSmithKline et al) and less so in those lower down the index.
Diversification is important. While investing in a pharmaceuticals giant or oil major might prove an excellent decision in the long term, it also exposes the investor to the possibility of stock-specific problems. Investing in a FTSE 100 ETF, while not escaping this issue (because a proportion of your capital would be in these companies), can mitigate it because the fund will also be invested in other, unrelated sectors, such as banking, housebuilding and technology. This helps reduce capital risk.
Thanks to their popularity, another great thing about ETFs is the number of options available for investors, making it easy to construct a customised portfolio in no time at all. Suspect that eurozone small caps might do very well? There's an ETF for tracking that. Think the Brazilian economy will recover in time? There's an ETF for tracking Brazilian companies too. Other providers now offer funds that invest in companies involved in potentially huge growth areas such robotics or cybersecurity - very appealing to those who have time to see their investments grow.
ETFs aren't perfect. Their very nature means that a fund can't outperform the index it tracks. In other words, you'll always get a slightly worse result than the market once the aforementioned (low) costs are taken into account. In contrast, making the right call on a specific company could see your wealth significantly and rapidly improve.
While the ongoing charges for holding some ETFs may be very low, the fact that they trade on the stock exchange also means that most investors will pay commission to buy and sell them, depending on their stockbroker. This is problematic if you have a habit of making impulsive decisions (because the charges stack up) or are only able to set aside modest amounts to invest each month. Therefore, while pound-cost averaging may work with index trackers (since no commission is charged), it's not as effective a strategy when utilising ETFs.
Ready to start?
Overall, ETFs can be considered a great tool for experienced and inexperienced investors alike but they're a particularly excellent starting point for the latter given their relative transparency, low cost and flexibility. Once you've become more familiar with how the stock market works and built up a core holding in instruments that track the market return, it should then be time to make the jump to investing in specific companies that you believe have the potential to outperform the market.
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Paul Summers has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.