To the average millennial, trying to understand the investment world is like trying to build a mansion from scratch; it's overwhelming, and they have no idea where to start. The world of investing is so vast that even the experts have a hard time keeping track of all the latest discoveries. On top of that, many young adults watched their parents' and grandparents' retirement savings vanish in the financial crisis of 2008-2009. As a result, many millennials have a "piggy bank" mentality, meaning they'd rather store their savings in a low-interest savings account than invest in securities that yield higher returns. According to a UBS report, millennials are holding (or hoarding) more cash than any generation.
As a millennial, I empathize with my peers; you can't fault us for avoiding something we understandably distrust. Not even 401(k)s and pension plans -- two of the safer investment vehicles available -- were spared from the carnage of the financial crisis. However, storing more cash than necessary in a bank account is a losing proposition, as cash decreases in value annually. Millennials need to put the Great Recession in perspective, recognize it for the periodic setback that it was, and learn to trust in the investment world. One great place to start would be with newer and safer securities like exchange-traded funds, or ETFs.
What is an ETF?
An ETF is a security that tracks an index (like the NASDAQ) or a large group of assets (stocks, bonds, etc.). A single ETF can hold thousands of securities, which gives owners broader exposure to the market. They've been around since the '90s but are now becoming mainstream; their hands-off approach and accessibility have earned them popularity among investors.
Here are some of the pros and cons of ETFs.
ETFs reduce risk
Only 27% of millennials own shares of stock, which means the average millennial is an investing novice. Having a diverse portfolio is a great way to protect new, inexperienced investors from risk of loss -- and millennials are more risk-averse even than their grandparents. Betting on an individual company's stock can be highly risky, because if that stock should tank, the shareholder could suffer tremendous losses. ETFs, on the other hand, spread the risk over a large group of stocks (or funds), which decreases overall risk. ETFs increase portfolio diversity by allowing investors to easily dive into multiple sectors without the risk of committing to individual, hand-picked companies.
ETFs don't require a huge investment
Contrary to popular opinion, millennials are exceptionally frugal consumers. They're smart shoppers who focus on the long-term value and durability of a product and tend to shy away from expensive name brands. Therefore many millennials may be hesitant to invest in securities that require minimum initial investments, such as mutual funds. Minimum initial investments typically range from $1,000 to $5,000. ETFs, however, are more welcoming to thrifty investors. So long as an investor has enough money to purchase a single share, he or she can become an ETF owner.
ETFs incur fewer expenses
ETFs may be more appealing to millennials because they incur fewer expenses than comparable securities. Not only are they passively managed, which means they have relatively low expense ratios, but they're also more tax-efficient. Due to the way they are structured, ETFs create fewer taxable events, or events that result in tax consequences. Together, these two features provide investors with savings unrealized in other security markets.
Yet there's no such thing as a perfect investment. Here are some of the cons of ETFs.
ETF owners have to pay brokerage commissions
When investors purchase ETFs, they generally have to pay their broker a commission, or brokerage fee. These fees can become costly depending on the investor's strategy. Investing a large lump sum of cash won't generate much in fees, but investing in small increments over a long period of time will. Unfortunately, many millennials, due to their often difficult financial situations and attitudes toward investing, might be compelled to use the latter investing strategy, which would significantly reduce any realized returns.
Note that some discount brokers offer commission-free ETFs -- but these can come with trading restrictions and high expense ratios. It's important to read the fine print before buying supposedly low-fee ETFs.
ETFs don't eliminate risk
ETFs may carry less risk than comparable securities, but no investment is risk-free. Even the safer ETFs that track broad-market indexes -- e.g., the SPDR S&P 500 (NYSEMKT:SPY) -- are subject to risk. In 2008, the S&P 500 dropped 38.5%, which means ETFs that were tracking it plummeted in value.
ETFs aren't perfect -- but what security is? Every security has its flaws. I still believe that investing in an ETF is a great way for millennials to not only become familiar with the investment world, but also learn to stomach market risk. Developing a higher risk tolerance is the only way millennials can achieve long-term wealth through investing.
Allen Screen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.