Etfs: Smart Short-Term Investment Strategy For Savings?

Exchange-Traded Funds (ETFs) are an increasingly popular investment vehicle, but are they the right choice for your savings? This article will explore the pros and cons of investing your savings in ETFs over three years and offer some alternative options.

ETFs vs savings accounts

Exchange-Traded Funds (ETFs) and savings accounts are both viable options for people looking to grow their money. However, there are several differences between the two that investors should be aware of before deciding where to put their money.

An ETF is an investment vehicle that holds stocks, bonds, commodities, or other securities. On the other hand, a savings account is a basic banking product where you deposit money, and the bank pays you interest on those deposits.

The most important distinction between the two is the potential for loss. ETFs carry varying levels of risk, depending on the underlying assets. While you can make more money than you would with a savings account, you are also exposed to losing money. Savings accounts, on the other hand, are low-risk as there is very little chance of losing your principal investment due to Federal Deposit Insurance Corporation (FDIC) coverage, which protects up to $250,000 per depositor per bank.

Another key difference is that ETFs are traded on stock exchanges throughout the trading day, and their prices can fluctuate. You can buy and sell shares at market prices at any time during market hours. In contrast, a savings account simply holds currency and does not experience price fluctuations.

Additionally, the potential for taxable income differs between the two options. Depending on the vehicle in which you hold an ETF, your gains may or may not be taxable. In contrast, savings accounts do not typically generate taxable income, as the interest earned is usually tax-free up to a certain amount.

When deciding between ETFs and savings accounts, it is essential to consider your financial goals, risk tolerance, and time horizon. If you are saving for a short-term goal or need easy access to your funds, a savings account may be a better option due to its stability and liquidity. However, if you are investing for the long term and are comfortable with taking on more risk, ETFs may provide the potential for higher returns.

It is also worth noting that you don't have to choose exclusively between the two. Diversifying your portfolio by combining ETFs and savings accounts can provide a balanced approach to saving and investing. This allows you to take advantage of the benefits of both options while managing your risk exposure.

Advantages of ETFs

Exchange-traded funds (ETFs) are an easy and straightforward way to begin investing your savings. They are a diverse and low-cost alternative to investing in individual stocks and can be ideal for beginners. Here are some of the advantages of ETFs:

• Diversification: ETFs provide exposure to a wide variety of stocks, bonds, and other assets, allowing investors to diversify their portfolios and reduce individual securities risk. This diversification helps to mitigate risk and is considered safer than investing in individual stocks.
• Minimal expense: ETFs are typically low-cost and provide access to a range of stocks, bonds, and other assets at a minimal expense. While they are not free, the fees tend to be lower than those of mutual funds.
• Simplicity and performance: ETFs take the guesswork out of stock investing. They are simple to understand and allow investors to match the market's performance over time, which has historically been strong.
• Liquidity: ETFs are more liquid and easier to buy and sell than mutual funds. They can be traded on major stock exchanges, such as the NYSE and Nasdaq, and online brokers make it convenient to buy or sell ETFs with a simple click of the mouse.
• Bond investing made easy: Investing in individual bonds can be extremely complicated, but bond ETFs simplify the process by providing access to a diverse range of bonds in a single investment. This makes it easy to include the fixed-income portion in your portfolio.

Disadvantages of ETFs

While ETFs are a popular investment vehicle, they do come with certain disadvantages that should be considered before investing. Here are some of the key drawbacks:

Fees and Costs

ETFs are traded on stock exchanges, and investors may need to pay a broker to facilitate the trade. These fees can range from $8 to $30 and are incurred every time shares are bought or sold. Additionally, ETFs have expense ratios, which represent the percentage of an individual's investment paid to the fund annually. While expense ratios for ETFs are typically lower than 0.5%, they can impact overall returns, especially for continuous small-volume trades.

Tracking Errors

ETF managers aim to align the fund's performance with the index it tracks. However, due to various factors, such as asset swaps or changes, the ETF may deviate from the index's holdings, resulting in tracking errors. This means the ETF could cost more than its underlying assets, and investors might pay a premium. Although uncommon, tracking errors can occur and may correct over time.

Limited Diversification

While ETFs generally offer a high level of diversification, some ETFs may be more narrowly focused. Certain funds might concentrate on specific sectors, countries, industries, or asset subclasses, limiting exposure to other areas of the market. Prospective investors should research the underlying risks of the ETF by understanding what it is tracking.

Liquidity Risk

Liquidity refers to the ease of buying or selling a security. ETFs with low trading volume or high volatility may be challenging to sell. Investors can assess an ETF's liquidity by examining its "bid-ask spread," the difference between the price paid for the ETF and the price it can be sold for. A large spread indicates illiquidity.

Capital Gains Taxes

ETFs that include dividend-paying stocks or generate capital gains through asset sales can distribute cash to investors, triggering tax liabilities. Shareholders are responsible for paying taxes on dividends and capital gains distributions. The tax treatment varies among ETFs, so investors should research the fund's policy before investing.

Lower Dividend Yields

While there are dividend-paying ETFs, the yields may be lower than those obtained by owning individual high-yield stocks. ETFs track a broader market, resulting in lower average yields. Investors seeking higher dividends may need to take on the additional risk of owning individual stocks.

Less Control

When investing in ETFs, individuals have less control over their investments as a professional selects the underlying assets. This lack of control may be undesirable for those who want to avoid investing in specific companies, industries, or asset types.

Designed to Track, Not Beat, the Market

ETFs are designed to track indexes, sectors, or other assets, and many track benchmarking indexes. Consequently, ETFs may not outperform the underlying assets in the index. Investors seeking to beat the market may need to consider other investment products.

How to invest in ETFs

Open a brokerage account

You will need a brokerage account to buy and sell securities like ETFs. You can do this online, and many brokers have no account minimums, transaction fees, or inactivity fees.

Find and compare ETFs with screening tools

Now that you have your brokerage account, you can decide which ETFs to buy. You can either go for the best-performing broad index ETFs or search for others using screening tools. Most brokers offer robust screening tools to filter the universe of available ETFs based on various criteria, such as:

• Administrative expenses or expense ratios: The lower, the better.
• Commissions: Fees paid per transaction when you buy or sell an ETF.
• Volume: An indicator of how popular a particular fund is.
• Holdings: The top holdings in the fund, or the individual companies the fund invests in.
• Performance: The fund's long-term performance, such as three-year, five-year, or ten-year performance.
• Trading prices: The current prices, which dictate how many shares you can afford to buy.

Place your order

The process for buying ETFs is similar to buying stocks. Navigate to the "trading" section of your brokerage's website and input the following:

• The unique identifier or ticker symbol for the ETF you want to buy.
• The current trading price, which is determined by the "bid" and "ask" prices.
• The number of shares you wish to buy.
• The order type, which can be a market order, limit order, stop order, or stop-limit order.
• The price per trade the brokerage will charge for its service.

Relax

Congratulations, you've just bought your first ETF! These funds can help form the basis of a well-diversified portfolio and serve as the first step in long-lasting investments in the markets.

Should I Invest My Savings in ETFs for Three Years?

While ETFs are a good investment option, the answer to this question depends on your financial goals, risk tolerance, and the amount of time you have to invest.

ETFs are typically recommended for long-term investments, and their value can fluctuate due to market movements and volatility. If you are saving for a short-term goal or building an emergency fund, savings accounts or cash management accounts are generally considered safer options due to their stability and liquidity.

However, if you are investing for the long term (typically over three years), ETFs can be a good way to diversify your portfolio and earn higher returns than you would with a savings account. They are also more flexible than mutual funds as they can be bought and sold during regular trading hours.

Additionally, ETFs have very low fees and are passively managed, meaning they are tied to an index or other benchmark. This makes them an attractive option for investors looking to keep costs low.

When deciding whether to invest your savings in ETFs for three years, consider your financial goals and risk tolerance. If you may need to access your funds within that time frame, a savings account or cash management account might be a better option. However, if you are investing for the long term and can withstand market volatility, ETFs could be a good choice to help you build wealth.

When to invest in ETFs

Exchange-traded funds (ETFs) are an easy and low-cost way to begin investing, especially for beginners. They are simple to understand and can generate impressive returns without requiring much effort from investors.

However, it is important to remember that investing in ETFs carries more risk than a savings account. While ETFs can provide impressive returns, there is also the possibility of losing money. Therefore, it is crucial to consider your financial goals, risk tolerance, and time horizon before investing in ETFs. Here are some key factors to consider when deciding when to invest in ETFs:

• Investment time horizon: ETFs are generally better suited for long-term investments. If you are saving for short-term goals (less than three years), a high-yield savings account or money market account may be a better option. Savings accounts offer more stability and liquidity for short-term goals.
• Risk tolerance: ETFs carry the risk of losing money if the underlying assets decrease in value. Before investing in ETFs, assess your risk tolerance and ensure you are comfortable with potential fluctuations in your investment value.
• Financial goals: Consider your financial goals and whether they are short-term or long-term. If you need the money for emergency funds, short-term purchases, or within the next three years, it is generally advisable to keep it in a savings account. On the other hand, if your goals are more long-term, such as retirement or building generational wealth, investing in ETFs can provide higher returns over time.
• Market conditions: Pay attention to market conditions and trends. While timing the market is difficult, investing in ETFs during a bear market (when share prices are generally declining) may not be advisable. It is generally better to invest during a bull market (when share prices are generally rising) to take advantage of potential growth.
• Diversification: ETFs are a great way to diversify your investment portfolio. They provide exposure to a variety of stocks, bonds, and other assets, reducing the risk associated with individual stocks. However, over-diversification can also be a concern, so ensure you carefully select your ETFs to align with your investment goals.
• Fees and expenses: ETFs typically have expense ratios, which are fees charged as a percentage of your investment. Compare the expense ratios of different ETFs and choose those with lower fees to maximize your returns.
• Tax implications: Investing in ETFs through a standard brokerage account can result in taxable income from capital gains and dividends. Consider using tax-advantaged accounts, such as IRAs, to minimize tax implications, especially for long-term investments.

In summary, investing in ETFs can be a great option, especially for beginners, but it is important to consider your financial situation, goals, and risk tolerance before investing. Ensure you have an adequate emergency fund and short-term savings in place before allocating money towards ETFs.

Frequently asked questions