Getting into share trading
Back when I was looking to get into trade shares, and I mean properly trade shares, not as a CFD but to actually own them and collect a divided, I was at first deterred by the barrier for entry. All up I was wanting to start with say, approximately $ 5000. The thing is, I didn’t want to put all my eggs in one basket and just buy one stock; I wanted to diversify and spread my stake across at least a few stocks so I was better protected.
My broker was charging a commission of $ 20 per trade on amounts less than $10,000. This isn’t too bad as far as brokerage fees are concerned but when purchasing only say $ 1000 or 2000 worth of shares, a $ 40 fee for buying and selling is quite excessive. Obviously, the more diversified and the more stocks, the higher the overall fees and it would quickly render the process of diversification too costly to be worthwhile. To have a diversified stock portfolio with handpicked stocks a much larger amount of capital than $ 5000 is required to get started but I still wanted to get involved with the share market and make my money work harder. After stumbling upon ETFs and Index Funds , I found that they were the ideal investment vehicle for those in my situation.
ETFs and Index Funds
Index funds are investments that generally attempt to mimic the performance of a benchmark or index. The most popular choice is the S & P 500, which is basket of the top 500 stocks by market capitalisation, weighted accordingly so that it tracks their combined performance.
ETF is an acronym for Exchange Traded Fund, which can be thought of as being a lot like an index fund for all intents and purposes with the major difference being that it is traded on the stock exchange just like an ordinary stock.
Other differences between ETFs and Index Funds
Aside from the fact that an ETF trades on the exchange whereas an Index Fund doesn’t, there are a few other key differences.
- NAV (Net asset value) – Since an index fund is updated every day at the closing bell to reflect the NAV of the S & P 500, its always worth what the S & P 500 is and cannot be bought or sold during intraday trading. ETFs can deviate from the NAV since they’re dictated by the market although they never deviate too substantially. They’re bought and sold during the market hours.
- The management fees can differ although they are both fairly low and competitive and can be less than 0.1% per annum!
- ETFs are generally more accessible than an Index Fund. Since only one unit is the minimum purchase, they’re cheaper to get into than an index fund which may require thousands of dollars to get comparable management fees.
- They’re taxed differently
- The way dividends are handled differs
Since both are effectively akin to owning regular stocks, albeit in a different form, they also collect a dividend, which should basically be the same as the dividend for the S & P 500, which has historically been somewhere around 2 % per annum. Index funds usually reinvest dividends commission free whereas ETFs don’t offer this.
So, which did I choose?
In the end I bought into Black Rocks iShares S & P 500 ETF (IVV) as an investment vehicle. Although there are differences between Index Funds and ETFS, unless you’re an active trader planning on buying and selling often rather than holding for long periods of time, they’re basically much of a muchness. I chose ETFs because they’re more tax efficient in Australia and specifically the IVV because BlackRock has a large size and reputation and good liquidity on the exchange.
Indices vs stock picking
I’ve heard some people comment that indices aren’t a good idea because they don’t really move much compared to other stocks. This probably stems from a comparison to the other small stocks that gained perhaps 50 % or more in a certain period while the S & P 500 may have only moved by 5%. This is exactly why most people should pick indices though; leave stock picking for those that have done the research, are passionate about what the company represents and have the capital to do so. Stock picking is extremely difficult and can be very hit and miss. As I highlighted early, it requires a large investment to get started properly with a diversified portfolio, which is an absolute must. Investing in an index means you are already diversified – if one stock takes a big hit, it is smoothed out by the rest of the index. If you had picked just a few stocks; the under performance of one stock has a much more drastic affect.