The start of this year wasn't an ideal advertisement for investing in the stock market, with worries over oil prices and the global economy sparking prolonged selloffs. But investing is still a great way to boost your wealth over time--if you use the right tools.
The most popular ways to save for the long term, while guarding against short-term crashes, involve mutual funds and exchange-traded funds (ETFs). Fundamentally, they're ways to invest in a lot of different stocks or bonds at once without your having to choose them one by one or to buy individual shares. This lets you diversify the companies, industries, or regions you invest in.
The differences between these types of funds come down to how nimble, and how narrowly focused, you want your investments to be. Mutual funds are less liquid--they're priced once per day after the market closes, unlike ETFs, which can be bought or sold whenever the stock market is open. And with mutual funds, you can't slice and dice your investment areas quite as thinly as you can with ETFs. But mutual funds are actually the better investment in most cases.
No matter the type, it's important to consider the cost of buying and selling the funds. This cost depends on whether your investments are actively managed by one or a team of financial professionals, or passively managed. Active management involves fees and sometimes load costs when a fund is purchased. Many financial advisers say that unless you're a sophisticated investor, you don't need active management; it costs more and better returns are hardly guaranteed.
Many experts advise starting with mutual funds that are low-fee passively managed index funds, so named because they're pegged to market indexes, and thus don't require active oversight. (The best known such mutual fund is Vanguard's 500 Index, which invests in 500 of the largest U.S. companies; State Street's SPDR, which mirrors the S&P 500 Index, is one of the best-known ETFs with the same goal.) These funds are the simplest, cheapest, and safest way to ensure that your money will do just as well as the market over the long haul.
For the average investor, having highly rated, low-cost index funds "and holding onto them for at least five years will get you the returns you hope for," says Barry Randall, an adviser with online investment manager Covestor.
Even Warren Buffett has advised his heirs to put most of his estate in "a very-low-cost S&P 500 index fund," as personal-finance experts Helaine Olen and Harold Pollack point out in their much-praised new book, The Index Card: Why Personal Finance Doesn't Have to Be Complicated.
"Most of us don't need a complicated, elaborately planned investment scheme that requires more choices and frequent changes. ... Don't let the perfect be the enemy of the good," write Olen, a journalist (and Inc. columnist), and Pollack, a professor at the University of Chicago School of Social Service Administration.
If you already have some established investments and want to take a more active role in your wealth management--or to increase your holdings in targeted areas--ETFs might fit the bill. The price of each piece of the fund can change by the minute, or even the second, throughout the day, so investors can quickly buy an ETF that's rising and sell one that's falling. So, in theory, if you have an ETF that's performing poorly, you can dump it immediately--though most advisers say that when to sell or buy depends on more than the market's being up or down. That's why Randall questions whether most people really want or need to be able to trade that fast. "All-day trading can be a virtue without value," he says.
If you plan to hold onto your investments for a long time, have no desire to become more hands-on with them, and are diversified in inexpensive mutual funds, there's no real need to plunge into ETFs. But if you do want to add some complexity to your portfolio, make sure you're willing to invest the additional time and careful oversight that requires.