A Complete Guide to Your First Investments
Forget buying your one share of Apple for a minute
Everyone’s first instinct when starting in investing is — I’ll buy 1 share of Apple.
That’s not a bad move — it’s a stable blue-chip company with good leadership, unrivaled products and viable growth strategies.
However, it shouldn’t be your first investment.
Your first investment should either be an exchange-traded fund or a mutual fund.
Here, we’ll be going over the basics of these two types of funds, why they’re great for beginners, and a few, in particular, you can consider.
- What are funds?
- Why you need them
- ETFs VS mutual funds
- Which one’s for you?
- Examples and the final word
If you’re interested in reading a broader introduction to investing, trading and asset classes, look at this article.
1. What are funds?
Both ETFs and mutual funds are portfolios or ‘baskets’ of stocks, which function like stocks themselves.
For example, the S&P 500 ETF (ticker SPY) contains 505 stocks, and its largest holdings are Apple, Microsoft, Amazon, Facebook, Alphabet, Berkshire Hathaway, etc.
By buying a share of the fund, you get proportionate exposure to all the stocks it contains. It’s a ‘stock’ that represents a much larger group of stocks.
If you invest $100 into the SPY, $6.94 of that is invested in Apple, $5.72 in Microsoft, etc. This makes it easy to invest in a lot of companies with very little capital to start.
Both ETFs and mutual funds are priced by their Net Asset Value (NAV), which refers to the total value of its portfolio divided by the shares that it has issued.
2. Why you need them
“Diversification is the only free lunch in finance” — Harry Markowitz, Nobel Prize for Economics.
Diversification is the name of the game. Holding a portfolio with tons of stocks allows their individual risks to be averaged out, allowing you to maximize your portfolio’s overall expected return while minimizing its overall risk(or variance).
ETFs and mutual funds are cheap, convenient and the number 1 way for entry-level retail investors to achieve diversification right out of the gate.
The basket structure allows you to get exposure to many stocks with just one share of the fund, so your capital doesn’t limit the diversity of your portfolio. It’s also insanely convenient because you don’t have to make your calculations for how many shares of individual stocks to buy, given your capital and the vastly different stock prices.
A fund should be your very first investment so that you can get exposed to potential returns immediately with relatively low risk, while you learn more about investing to further refine your own style.
Later on, with more knowledge and experience, you can use individual stock positions to offset or augment a portfolio built on funds.
Today, both ETFs and mutual funds are also so well-developed that you can use them to craft more advanced thematic strategies. Smart mobility, EVs, solar energy, education; if you can name it, you can find it. See more theme ETFs on ETF.com.
3. ETFs VS mutual funds
3a. Passive VS active
ETFs are mostly designed to track an index. For example, the SPY tracks the S&P 500 index by buying/selling stocks to maintain the same portfolio composition as the index.
This is a passive style, where no independent decisions are made about what to invest in. Everything follows the index.
On the other hand, there are both passive and active mutual funds. Some of them track an index and behave the same way as ETFs; however, others have a team of investment professionals who analyze stocks and decide how to invest, with the aim of beating a certain benchmark index. This is also called a relative return strategy.
Simply put, when you invest in an active mutual fund, you’re hoping the manager is smart enough to grow your money faster than the benchmark.
3b. Fees
ETFs are generally cheaper than mutual funds.
Both ETFs and mutual funds have expense ratios, which is an annual percentage-based fee. ETF expense ratios are generally 0.1–0.7%, while mutual fund expense ratios trend higher at 0.5–1%.
That’s to say, for every $100 you invest in a 0.5% ER fund, you pay them $0.50 a year. That fee will be automatically deducted from your account.
Also, mutual funds may charge a load and/or commissions, though nowadays, it’s usually just the former. The load is essentially a sales charge, and funds may be front-end load (paid when you buy a share), back-end load (paid when you redeem the share), or level load (paid consistently throughout) — more on load here.
ETFs don’t come with loads but don’t forget that your broker may charge a small commission for trading them.
ETFs also have a slight tax advantage to reduce costs for investors who aren’t using a tax-deferred 401(k).
3c. Liquidity
Another important distinction is how these funds are traded. You can buy and sell ETFs at any point in the day on the open market at the prevailing price, like a stock.
However, mutual funds are not traded so easily. They’re ‘marked-to-market’ at the end of the day, a process in which their Net Asset Value is calculated from market prices of the stocks they hold. Shares of mutual funds can only be bought and redeemed once a day, after the mark-to-market.
ETFs are also marked-to-market, but that happens throughout the day, and the deviations from NAV are minuscule — the intraday prices are always almost exact.
That means it’s much harder to get in and out of mutual funds at fair market price, which in investing jargon is ‘less liquid.’
3d. Open VS closed
All ETFs are open-end funds, and some mutual funds are closed-end funds. Open-ended funds create new shares for whoever wants them, while closed-ended funds only ever circulate a fixed amount of shares.
This means that for a closed-end fund, its price may be driven higher or lower than it’s ‘fair’ Net Asset Value depending on demand for its shares.
To begin with, it’s always a good idea to stick to open-ended funds, where the price of a share stays very close to Net Asset Value.
3e. Where to buy
An ETF, like the name suggests, is bought and sold on an exchange, which means you can buy them wherever you can buy stocks.
In comparison, mutual funds are a little more complicated; they’re bought through the fund issuer or your broker, and your 401(k) may already be invested in them.
Your stockbroker can probably sell you mutual funds, but the list of mutual funds available is typically limited for each broker. Make sure to check what they have on offer before diving deep into fund research.
Some links that may be of help:
4. Which one’s for you?
4a. Your time involvement
Passive investments are easier to make. As long as you’re happy having your portfolio follow a major index, you can buy any of the major ETFs or index-tracking mutual funds and rest easy. Set-and-forget.
If you want to invest in an actively-managed mutual fund, then you have to not only decide which index you want to beat, but also spend time researching the assortment of mutual funds trying to beat it.
4b. Your level of control
There’s the element of discretion in active mutual funds, so you have to trust the issuer and manager you’re giving your money to.
ETFs are very transparent since the components of their underlying indices are well-known. On the other hand, mutual funds won’t tell you all the positions they hold.
Mutual funds are also less liquid. If you want full control over your investments, or if you want the freedom to change your mind at any moment, stick with the highly-liquid ETFs.
4c. How much you want to make
Actively-managed mutual funds should intuitively provide better returns than passive ones — and they usually do — but that’s not necessarily the case.
A typical relative-return strategy consists of allocating a vast majority of the fund portfolio to its benchmark, then using the small remaining portion to get some extra performance.
That way, the fund won’t lose out to the benchmark too much if the manager makes some bad decisions. However, that also means that the potential upside is minimal.
Do your research on the fund management and its track record. While its past performance isn’t an indication of future returns, it can tell you a little about the manager and issuer’s experience and proficiency.
You may decide then that the increased fees and lower liquidity (compared to just buying a benchmark ETF) is compensated for by the fund’s potential to outperform the benchmark.
For example, over the last 5 years, the Growth Fund of America (ticker AGTHX) has achieved a 16.91% annualized return, compared to the S&P 500’s 14.46% — the difference more than paid for the higher expense ratio assuming you held on to AGTHX through those years.
5. Examples and the final word
To start, look into the biggest funds i.e., those with the largest assets under management (AUM). Here’s a shortlist, and you can find out more about them on ETF.com.
ETFs: S&P 500 (SPY), Nasdaq Composite (QQQ), Dow Jones Industrial Average (DIA)
Passive Mutual Funds: Vanguard 500 Index Fund Admiral (VFIAX), Fidelity 500 Index Fund (FXAIX)
Active Mutual Funds: The Growth Fund of America (AGTHX), Fidelity Contrafund (FCNTX)
Both ETFs and mutual funds have greatly democratized the world of investing, and as a beginner, there’s really no better way to get your feet wet than putting a little cash into a big fund.
To lower your risks even more, use dollar cost averaging. All that means is dividing up your money to invest fixed amounts at regular intervals, to avoid poor timing by averaging out the price at which you buy-in.
If you want specifics on how I’ve been investing and trading, feel free to read this walkthrough I’ve written about my own experiences.
Otherwise, all the best on your investing journey.
All information presented is for educational purposes only, and not to be construed as legal, tax, investment or financial advice.
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