Finding the money to contribute to your retirement account is only half the battle. Then, you must decide what you're going to invest that money in so you earn the largest possible return without exposing yourself to too much risk. The more you grow your nest egg through investment earnings, the less of your own money you must set aside every month for your retirement, so it's a big decision.
Exchange-traded funds (ETFs) are one option worth considering. They've grown significantly in popularity over the last decade because of the flexibility, affordability, and diversification they offer. I get into some of their key benefits for retirement savings below, but first, let's take a closer look at how ETFs work.
What is an ETF?
An exchange-traded fund (ETF) is a basket of investments that can be traded on an exchange, just like a stock. It's similar to a mutual fund, except mutual fund share prices are set at the close of each day, while ETF share prices are determined by market participants during the trading day at whatever time you place the order.
Many, though not all, ETFs track a market index, like the S&P 500. The ETF contains the same investments as the index, so when the index performs well, the ETF does too. These types of ETFs tend to generate consistent, high returns.
Benefits of ETFs for retirement
Here's a look at some of the key reasons you should consider adding ETFs to your retirement portfolio.
1. They offer instant diversification
ETFs, like mutual funds, enable you to invest your money in many different companies without buying all of the individual stocks that make up the fund. Diversification is always important because it reduces your risk of loss. If you have all your money invested in one or two companies and their stocks plummet, you'll lose a lot of money. But if you have your money in 100 different companies and a few are performing poorly, it won't affect you as much.
Of course, not all ETFs provide the same level of diversification. Sector ETFs, for example, like healthcare ETFs or industrial ETFs, offer diversification within a given sector, but you'll need investments in other sectors as well if you want broad market diversification.
2. You don't need a lot of money to invest in ETFs
You can purchase shares of some ETFs with as little as $50, while some mutual funds require a minimum initial investment of several thousand dollars. These lower costs make it easier for those who may only be able to contribute a small sum toward retirement every month to invest in something that provides diversification and solid returns.
The low initial investment also makes it easier to invest in multiple ETFs, whereas if you were sticking to mutual funds, you might need thousands of dollars in your retirement account before you could think about doing this.
3. ETF fees are usually low
Many brokers offer zero-commission ETFs, so you won't owe a fee every time you buy or sell. But this isn't true of all ETFs, so it's important to investigate the fees of each one you're considering rather than just assuming it doesn't have a commission.
ETFs have expense ratios, just like mutual funds. These are annual fees charged as a percentage of your assets that all shareholders pay. Some mutual fund expense ratios can be upwards of 1%, which means you're paying $10 for every $1,000 you invest. But many ETFs passively track a market index. This requires less work on the part of fund managers and results in lower expense ratios. Some have expense ratios of 0.10% or less, which means you're only paying $1 or less for every $1,000 you invest.
Even a $10 annual fee might not sound like much, but these fees add up over time, especially when you have larger sums in your retirement account, so you want to pay as little as possible.
When you're talking about your life's savings, you need to be choosy about what you do with it. If you haven't thought about adding ETFs to your portfolio before, now is a good time to do so. There are plenty of low-cost ETFs out there, and your options will likely only grow with time as these funds gain even more popularity.