Why ETFs should be the building blocks of your portfolio
If you had to pick just one company on the Australian share market that you're convinced will have a higher share price a year from now, which would it be?
On the surface, it sounds like an easy challenge. After all, there are more than 2000 companies listed on the Australian Securities Exchange (ASX) including our biggest and most-recognised businesses.
Yet, as we've all witnessed since the outbreak of COVID-19, there are no guarantees when it comes to investing. It's impossible to predict the course of financial markets, let alone the future share prices of individual companies.
Which is why a growing number of Australians are choosing to invest in a very different way.
Rather than trying to find company shares that could possibly increase in price over time, they're accessing financial products that have investments in hundreds, and in some cases thousands, of listed companies around the world.
The logic is simple. To paraphrase the words of Vanguard's founder John Bogle, why look for a needle in the shares haystack when you can easily buy the whole haystack (i.e. the total share market)?
Finding your portfolio building blocks
So, how are these investors doing that?
Primarily, they're using a wide range of professionally managed funds, including funds that are readily bought in the same way as shares on the ASX, known as exchange traded funds (ETFs).
ETFs and managed funds are often referred to as core portfolio building blocks, because they provide low-cost, very broad market exposures through their shareholdings in many companies spanning a wide range of business sectors.
Most of the biggest ETFs and managed funds are designed to track the wider performance of markets. When you invest in them, you are essentially buying a big slice of the total market.
In Australia, for example, it's easy to buy one ETF in a single ASX trade that covers the entire top 300 Australian-listed companies ranked by their market values.
There are also ETFs listed on the ASX with holdings in thousands of other listed companies in markets such as the United States and Japan, and some even cover multiple markets across Europe and Asia.
In short, managed funds including ETFs provide a level of diversification that most investors couldn't possibly achieve on their own without spending large sums of money.
Broad diversification across markets and different assets inevitably spreads risk, and thereby reduces overall portfolio volatility. That's a big part of the reason behind the massive inflows into ETFs this year.
As the COVID-19 crisis escalated over February and March, and markets became more volatile, small investors poured billions of dollars into the Australian ETFs sector as a means of reducing their risk and to take advantage of lower market prices.
The importance of starting early
Managed funds and ETFs are not new financial products, but their popularity is increasing across all age groups including among younger investors.
That's a positive development, as history continues to show us that share markets have consistently delivered strong growth over time.
By reinvesting distributions (mainly dividends) and making additional contributions, even a low initial balance will grow substantially over time when combined with compounding investment returns.
In fact, the earlier you start investing the higher the potential returns in the longer term.
That's illustrated in the table below, which compares two individuals the same age who start off with the same investment amount. They also each make regular additional contributions through the year. The only difference is one starts investing five years after the other.
Investing is all about the future, and waiting only a few years can make a big difference to long-term financial outcomes.