To understand ETFs, or Exchange-Traded Funds, we need to picture an analogy first. Imagine you have a basket of fruits. These are different fruits of different sizes. When you buy such a basket, you buy every fruit inside. An ETF is just that, but instead of fruits, it contains stocks. An ETF is a “pre-built” stock portfolio, managed passively by the issuing firm.
Let’s visualize it in a different way. Imagine you have a pie. This will be your ETF. You can cut the pieces evenly, or of different sizes. The slices are the stocks the ETF is made of. If you invest, for example $50 in one such pie, then that money will be distributed in each slice according to the size of the slice.
People generally invest in such portfolios because of the two main benefits they bring:
Diversification. Instead of only buying, for example, $50 of one company, you can use those $50 to buy an ETF with 30 companies. Diversifying your portfolio helps because if one of your investments drops in value, your overall portfolio won’t drop as much as if you would have invested in just that one company. Imagine this: you invest $100 in a company that drops in value 10%. You now have $90. However, if you invest those $100 in an ETF with 10 companies and one of them drops 10% in value, you will have $99. This is an amazing way to protect yourselves from market fluctuations.
Lower cost. Usually, if you want an expert to manage your money, they will ask for a part of the profits. Because ETFs are managed passively, they have a way lower management fee. The standard is under 1%, while people that manage money actively charge 2% or more. Even if it doesn’t seem like much, over time, compound interest will make that 1% count.
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