The best way to understand anything that seems complicated is to just try it yourself. I learned how to invest by basically clicking on a bunch of buttons, and I didn’t fully grasp how an ETF works until I attempted to buy one myself.
And the second best way? Seeing what someone else did in a similar situation. How they weighed their options, and why they chose what they did. This is invaluable for learning how to apply ideas to your own circumstances. While you can read books on investing, sometimes the best way to get concepts to stick is through anecdotes and context.
Well, my friends, I finally got an investing question I can reasonably answer AND can hopefully serve as a teachable moment.
Per usual, I am not a financial professional, so please don’t take my advice and then sue me!
Now that we have that legally binding contract out of the way, with reader permission, here’s the question:
I just opened a Vanguard Roth IRA account! I am very excited. Aside from my job matching my 401k, this is my only investment venture. I plan to transfer $500 into my account every month, so currently I have $500 in my money market account. Index funds cost between $1000 to $3000. I want to have a diversified portfolio and planned to have about 32% in bonds and the rest in stock. (I am 32 years old btw). I was thinking the Vanguard Total Stock Market (VTI) or Vanguard 500 Index Fund (VFIAX) and Vanguard Star Bond Fund (VGSTX). I really just want to allocate the percentages and just leave my accounts alone.
My question is, do you think I should just wait to have enough money to make the purchase of index funds, or should I just purchase ETFs since they don’t cost as much, and there’s no minimum. What do you think about the index funds that I’m considering?”-S
S wants to know:
Should she buy exchange-traded funds (ETFs) now, because the mutual fund minimums are currently out of reach?
If you’re new to investing, and are probably intimidated by all the foreign vocab, let’s take a step back. Here are the general steps to venturing into investing on your own.
- Step 1: Already contribute to your company’s retirement plan (if available).
- Step 2: Annihilate credit card debt.
- Step 3: Set aside money in a high-yield savings account.
- Step 4: Choose a broker.
- Step 5: Choose an account type and transfer money to the account.
- Step 6: Shop around and decide what to buy.
- Step 7: Choose your portfolio mix, aka “asset allocation.”
- Step 8: Place the order.
Note: S is facing steps 6-8 because she’s investing on her own from scratch, which is the cheapest way to invest. If she were investing with a robo-advisor, it would cost a little bit more, but the robo-advisor would also make these decisions for her.
S is already investing in her company’s 401k. She’s now ready to venture into investing on her own for the first time.
S is also pretty far along on steps 6 and 7. She just needs a little help on the execution.
She’s chosen Vanguard as the online broker where she can place her orders. Other popular brokers are Fidelity and Charles Schwab. (I invest with all three).
From their many account options, she’s opened up a Roth IRA.
As for her asset allocation, she’s planned to put 32% into bonds, and the other 68% would go to stock.
Right off the bat, there are two things S mentioned that definitely sway me in one direction:
“I plan to transfer $500 into my account every month…”
“I really just want to allocate the percentages and just leave my accounts alone.”
But first, what are ETFs and mutual funds, and how are they different?
Practical Differences Between ETFs and Mutual Funds
Both ETFs and mutual funds are a collection of investments. It’s like a grab bag with many items inside. For example, a stock ETF or mutual fund would include shares of companies you probably know and use every day, like Amazon, Apple, Microsoft, and hundreds of other companies. If those companies do well, your investment grows, too. Both options S is looking at basically hold a high concentration of these stocks:
PS. These are great for diversification, so you’re not putting all your eggs in one basket. With multiple companies, it’s a lot less risky than investing in a single company that might not perform.
Even years into investing, I didn’t know how an ETF was different from a mutual fund. Intellectually I did, but the pros and cons I read about were way too advanced for a newbie investor like me. I didn’t fully grasp the practical differences until I went to make a trade on my own.
While there are more pros and cons you can read about here, to me the most relevant differences for beginners is how you buy them:
The big differences are that you need more money upfront to buy mutual funds for the first time (at least with Vanguard), and you can’t auto-invest with ETFs. Prices also fluctuate during the day. With mutual funds, even if you make a purchase at 10am, the price you get will be the one it happens to be at 4pm.
ETFs are also supposed to be more tax-efficient, but I haven’t seen hard numbers to compare, and S is investing within a Roth IRA, which is already tax advantaged.
S has mentioned a few times that she wants to set it and forget it. She would set up a $500 per month transfer, leave her percentages alone, and go about her merry way. So right now, I’m leaning towards mutual funds since she would have to manually place trades with ETFs.
ETFs and Mutual Funds: Which Is Cheaper?
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Investing costs money. Although the prices keep falling as brokers compete against one another. It used to cost me a $4.95 commission every time I bought a stock or ETF with Charles Schwab. Now they’re commission-free.
With my mutual funds, there’s no commission fee. However, both ETFs and mutual funds charge operating costs, or expense ratios, which are percentage-based. One of my mutual funds has a 0.03% expense ratio, which means I pay $0.30 for every $1,000 invested in the fund. The math for this can get overwhelming, especially as you open more investment accounts, so I track the fees with Personal Capital‘s Retirement Fee Analyzer. Below is a screenshot of what I’m paying.
S said she was considering ETFs, because “they don’t cost as much.” In general, ETFs cost less, but I’d caution against blanket statements. The only way to find out for real is to compare specific funds side by side. I followed up with S for the exact ETF she was considering, so here’s what we’re looking at:
Note: a quick way to identify if something is an ETF or mutual fund. The letters in between the parentheses are ticker symbols, unique identifiers for everything you can buy in the stock market. Notice how the ETF is three letters, while the mutual fund has five.
Let’s scope these fees:
VTI purchased through Vanguard has no commission fee, so we’re even there.
And the operating costs?
VTI has a 0.03% expense ratio.
VFIAX has a 0.04% expense ratio.
Note: Expense ratios aren’t always the only fees with mutual funds. Steer clear of purchase, load and redemption fees.
So, if S buys VFIAX, the mutual fund, how much of an impact does the 0.01% difference make over the long term?
I used Nerdwallet’s fee comparison calculator to check. Assuming a $6,000 annual contribution for 35 years, and an optimistic 10% return, the mutual fund could cost an extra $3,751.
S has to ask herself if the auto-investing feature is worth the extra costs. For me, that spread isn’t high enough to make the easier-to-purchase ETF a slam dunk.
ETFs Are Easier to Get Into
Now onto the biggest issue: the mutual fund S wants has a high barrier to entry—that $3,000 minimum. Lots of young investors don’t have that kind of cash laying around. If S bought the VTI ETF, she could get in for less than $200. For people who want to get into the market right away, don’t have much money, and don’t mind manually investing, then ETFs are a good solution.
For S, it will take her about six months to set aside the minimum to buy the VFIAX mutual fund. I have no doubt she can do it, but she also seems really excited to get started. When it comes to money, there’s something to be said about momentum. You’ve got to strike when the iron is hot!
Another Idea: Look for a Mutual Fund with a Lower Minimum
Investing is not an all-or-nothing decision. S can start one way, then change things up later.
If she’s set on a mutual fund, and wants to get in earlier, what S can do is look for a mutual fund with a lower minimum. With Vanguard, there aren’t very many. But I see two options: the Vanguard STAR Fund (VGSTX) or a Target-Date fund. There are many target-date funds, and you pick the one with your approximate retirement date in the name. Although I like to go more aggressive, so for S, I would look at Vanguard Target Retirement 2060 Fund (VTTSX). Each have a minimum initial investment of $1,000.
So instead of saving up for six months, she could get in the market in just two. Then, once she has the $3,000 a few months later, she could exchange for the VFIAX she really wants. This is exactly what I did many moons ago.
Two things to note about VGSTX (the Star fund) and VTTSX (the target-date fund):
- The expense ratio for VGSTX is 0.31%, which is 10 times higher than VFIAX. However, she would only be holding it for a few months, so I wouldn’t be too concerned about fees in this situation. VTTSX is 0.15%, so much less.
- Both funds are “balanced funds,” which means they’re a pre-made mix of stock and bonds funds. The makeup of each:
- VGSTX: 60% stocks and 40% bonds
- VTTSX: 89% stocks and 11% bonds
If she were to buy either of these, she wouldn’t need that separate bond fund she mentioned in the e-mail. She would just buy one of these funds and set the asset allocation as 100%.
Both are decent options to start with, although VTTSX has the edge for me:
It’s less expensive, has an asset allocation that more closely matches S’s profile, and it will automatically rebalance to shift more to bonds as she gets older.
If she sticks with the original plan–buying VFIAX and a separate bond fund–she will have to manually rebalance her percentages every now and then.
Don’t Minimize the Importance of Asset Allocation
S asked me what I thought about the funds she chose. The truth is, once you start comparing them side by side, you will be hard-pressed to find significant differences. The fees are a much larger factor to me.
Also, there was one thing that S mentioned and didn’t ask me about:
“I want to have a diversified portfolio and planned to have about 32% in bonds and the rest in stock.“
If it were me, I’d double-check the asset allocation of having 32% in bonds. S is young, and assuming that S will be using the money for retirement decades down the line, that mix seems a little conservative to me.
Asset allocation, or the breakdown of what you invest in, is important because it has to do with your time horizon and risk tolerance. The higher your percentage in stocks, the higher the risk, but also the higher the chances you make more money. And the longer the timeframe, the more you can withstand the stock market going up and down.
You can invest in many different things, but for most beginners, they’ll be buying stocks and bonds at first.
S’s current planned allocation looks like this:
- 68% stocks
- 32% bonds
It looks like she’s using the “Age in Bonds” rule. She’s 32, so let’s allocate 32% to bonds.
There is no hard rule for how you should divvy up your investments, but I would consider other ideas. Another general rule of thumb for stock and bond allocation:
120 – your age = how much you allocate to stocks
Note: The starting number used to 100, but people started living longer, so that got outdated.
So for S, it could look like:
120 – 32 = 88% stocks
So then 12% would go to bonds. Again, this isn’t a hard-and-fast rule, but meant to give beginners a starting point. Once you get more comfortable, you can ignore the age rules entirely and adjust based on your own personal risk tolerance (what I do).
Summary: Should You Buy ETFs or Mutual Funds?
It all depends on how much money you have to work with, and what you prioritize. For the DIY investor, in general, ask yourself, what kind of investor are you?
- If you want to get in the market ASAP and don’t have $1,000, go for ETFs. Note: these minimums apply to Vanguard only. Both Fidelity and Charles Schwab offer zero-minimum mutual funds. As I’ve mentioned, I have accounts with all three, although now Charles Schwab offers a $100 sign-up bonus, even for opening a checking account.
- If you want to set it and forget it with repeated, automatic transactions, go for mutual funds.
- If you are investing in a taxable account and value tax-efficiency, you may want to investigate ETFs, although I haven’t seen any real calculations to compare.
- If you are an active investor who wants more control over pricing and buying options, then go for ETFs, but look for commission-free options.
Do you DIY invest? If so, have you chosen mutual funds or ETFs? What would you do in the reader’s situation?
Featured Image: Unsplash