What Makes ETFs a Smart Move for Small Investments

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Not everyone has thousands of dollars in disposable income just waiting to be invested.  For many investors just starting out, money could be tight and what seems like chicken feed to the big players might be a comparatively large nut to someone just entering the stock market.  Those with just $500 extra cash can still get started in investing and ETFs may be a smart way to begin now.

The stock market is not just for King Midas and his ilk; there are ways to buy stocks and make small investments with very little money.

Rachel Rabinovich, a CFP at Society of Grownups stresses, would say the first thing anyone considering taking on investment risk should do is to be certain they actually have the money to invest by ensuring their finances are in order.  It is important to build an emergency fund and keep any money they might need within five years out of the market.

Because investors will have time to recover from market hiccups, investing in stocks is a practical way to cultivate cash for a longer term goals.  Rabinovich says, “You need to be OK with losing the money you invest, at least in the short term.”

One of Warren Buffett’s favorite investments for most Americans is ETFs.

Exchange traded funds, or ETFs, are a smart way for people with a small amount of money to get started with investing.  There are low-cost ETFs out there for a variety of risk tolerances and investment objectives.  An ETF is a marketable security tracking a particular index and trades on a major stock exchange.  Having some properties of both mutual funds and common stock, ETFs are available to invest in stocks, bonds, and commodities.  They are similar to mutual funds as they allow investors to disperse money without depending on any single stock or bond or directly owning any commodities.  An S&P 500 ETF would hold all 500 stocks included in the index, in the same proportions, for instance.

Getting started with investing in ETFs is even more attractive as people can often avoid paying trading commissions.

By investing directly through a broker who offers commission-free ETFs or going directly through the ETF issuing company (like Vanguard), investors can avoid paying trading fees.  For instance, at this time, there are in excess of 300 commission-free ETFs from which to select, if one is enrolled with TD Ameritrade.

Matthew Frankel at The Motley Fool has this example: “Let’s say that I want to invest in the Vanguard Mid-Cap Growth Index Fund ETF (NYSEMKT: VOT), my personal favorite mid-cap growth ETF, which trades for just under $119 per share as I write this, and is on my broker’s commission-free list. I could take my $500, buy four shares of the fund for $476, and not pay a dime in commissions. As time goes on and I want to add more to my portfolio, all I need is enough money to buy a single share of this or another ETF.”

There are a sizable number of ETFs available and those numbers are increasing, making it easy for people to find personally interesting stocks to invest in.

The decision on what sector or sectors hold the most potential is important and should be considered carefully to narrow down the most suitable sector and most interesting stocks within that sector.

Why invest in ETFs?  Because there are cost advantages over investing in mutual funds.

Mutual funds usually charge their customers fees based on a percentage of the total assets under management; this is known as the expense ratio.  As well as covering the salaries of the fund managers, the expense ratio encompasses all other operating costs.  By comparison, ETFs usually have lower expense ratios because their operation costs are inherently lower.  Even though this cost differential is small, it can amass over time to a considerable amount due to the nature of compounding.

Index funds, particularly actively managed funds, will subject investors to taxes when the fund’s company shares are sold at a profit; this can happen every year.  Fund owners must pay a capital gains tax on any reported profits.  Conversely, ETF investors do not incur any capital gains taxes until they, the investors, sell fund shares.  If the selling price is higher than the purchase price at the time of sale, they may be liable for taxes.  ETF investors have control over when they are subject to taxable events.

The majority of index funds require shareholders to have a minimum investment when opening an account; this initial investment can be rather large, depending on the fund.  To avoid maintenance fees, many funds require investors to sustain a minimum investment level.  Alternatively, ETFs do not have minimum fees because shares are purchased just like stock.

As with any type of investing, there are a couple of things of which to be aware with small investments in ETFs.

Unless commission-free, there is a cost to buying and selling the shares of ETFs, which can be a disadvantage.  ETFs are bought and sold like stocks, which means costs can vary considerably, depending on the broker.  For instance, paying $10 to $20 in commissions and fees on a $100 monthly investment will substantially eat into an investor’s returns.  As mentioned previously, there are brokers who charge very small or no fees for ETF purchases and sales; though there are limitations, these ETFs might be worth researching.

There is a spread between the buying and selling price of any stock.  The wider the spread, the more valuable the stock must become in order to cover the higher purchase cost and lower selling price.  As with any stock, ETF spreads will depend on the volume and liquidity of the market.  The buy and sell price of ETFs, as with stocks, will vary throughout the day, which can lead to opportunities to buy at a lower price, or, getting stuck buying at a higher price as the ETF shares close down.  It is a recommended practice for investors to use limit orders to give them control over trade prices.

ETFs can get traders into the market with a low minimum investment, unlike several other investment paths. 

Of course, there is risk which must be understood before any investment: market volatility and the volatility of the ETF’s trading index must be considered, as well as commission fees associated with trades, which can be insignificant with no or low-fee ETFs.

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