What an ETF is and why people buy them

An exchange-traded fund (ETF) is a collection of stocks, bonds, or other securities bundled together and sold as a single investment. When you buy one share of an ETF, you own a small piece of everything inside it. For example, an S&P 500 ETF holds shares in 500 large US companies, so one purchase gives you exposure to all of them at once.

People invest in ETFs because they spread risk across many holdings instead of betting on single stocks, they trade during market hours like regular stocks, and they typically charge lower fees than actively managed mutual funds. An ETF that tracks the S&P 500 might cost 0.03% per year, while a mutual fund tracking the same index might cost 0.50% or more.

ETFs are not the only way to invest — you can also buy individual stocks, bonds, mutual funds, or other assets. But ETFs have become popular because they are simple to understand, inexpensive, and available through any brokerage account.

Key Takeaways

  • You need a brokerage account with a bank or investment firm before you can buy any ETF.
  • ETFs trade during market hours like stocks, so you can buy and sell them any time the market is open.
  • The cost of owning an ETF is shown as an expense ratio, which is a percentage of your investment charged each year.
  • Broad index ETFs that track the whole market or large segments of it carry less risk than ETFs focused on single sectors or countries.
  • You can hold ETFs in a regular taxable account or in a tax-advantaged account like an IRA or 401(k).

Opening a brokerage account

Before you can buy an ETF, you need a brokerage account — a place to hold your money and execute trades. Common brokerages include Fidelity, Vanguard, Charles Schwab, E*TRADE, and Robinhood, though many others exist. Each one lets you open an account online in 10 to 20 minutes by providing your name, address, Social Security number, and employment information.

Most brokerages offer both regular taxable accounts and tax-advantaged accounts like IRAs. A regular account has no contribution limits and you can withdraw money anytime, but you pay taxes on gains and dividends each year. An IRA lets you contribute up to $7,000 per year (or $8,000 if you are 50 or older as of 2024) and delays or eliminates taxes on growth, but you cannot withdraw before age 59½ without a penalty in most cases.

You will need to fund your account by linking a bank account or transferring money from another investment account. Most brokerages do not charge a fee to open an account or hold cash in it.

Choosing which ETF to buy

ETFs fall into broad categories based on what they hold. Index ETFs track a specific benchmark — the S&P 500, the total US stock market, international stocks, bonds, or combinations of these. Sector ETFs focus on one industry like technology, healthcare, or energy. Factor ETFs target stocks that meet certain criteria like high dividend yield or low volatility. Thematic ETFs bet on trends like renewable energy or artificial intelligence.

For someone starting out, broad index ETFs carry less risk because they hold hundreds or thousands of holdings. An ETF tracking the entire US stock market holds roughly 3,500 companies, so any single company's poor performance barely moves the needle. A sector ETF holding only technology stocks is more volatile — if tech falls out of favor, the whole fund drops faster.

Look at the expense ratio — the annual cost shown as a percentage. A 0.03% ratio on a $10,000 investment costs $3 per year. A 1% ratio on the same investment costs $100 per year. Over decades, that difference compounds. Compare expense ratios for ETFs tracking the same index, because many brokerages offer multiple versions of the same thing.

Placing your first trade

Once your account is funded, buying an ETF takes three steps. First, search for the ETF by its ticker symbol — a short code like SPY (S&P 500), VTI (total US market), or BND (US bonds). Your brokerage will show you the current price, the expense ratio, the holdings, and performance history.

Second, decide how many shares to buy. If an ETF costs $150 per share and you have $3,000 to invest, you can buy 20 shares. Most brokerages now allow fractional shares, so you could also invest exactly $3,000 and own 20 full shares plus a fraction of another.

Third, place the order. You will choose between a market order (buy at whatever price the market is trading right now) or a limit order (buy only if the price drops to a number you set). Market orders fill immediately during trading hours. Limit orders may never fill if the price never reaches your target. Most new investors use market orders for simplicity.

Understanding costs and taxes

The main cost of owning an ETF is the expense ratio, which is deducted automatically from the fund's value each year. You do not write a check — it just reduces your balance. A $10,000 investment in an ETF with a 0.10% expense ratio will cost $10 per year, whether the fund gains or loses money.

Some brokerages charge a commission per trade, though most major brokerages have eliminated this fee. Check your brokerage's fee schedule before opening an account. A few brokerages charge inactivity fees if you do not trade for a certain period, though this is rare.

In a taxable account, you owe capital gains tax when you sell an ETF for more than you paid, and you owe tax on any dividends the ETF distributes. ETFs are generally tax-efficient because they trade less frequently than mutual funds, but you still pay tax on gains and dividends each year. In a tax-advantaged account like an IRA, you do not owe tax on gains or dividends until you withdraw the money (or ever, in the case of a Roth IRA).

When to buy and how much to invest

The best time to start investing is as soon as you have money to invest and a brokerage account open. Trying to time the market — waiting for a price drop or buying before a rise — is difficult even for professionals. Most financial advisors recommend investing a fixed amount on a regular schedule, whether the market is up or down. This is called dollar-cost averaging, and it removes emotion from the decision.

How much to invest depends on your financial situation. Financial advisors often suggest building an emergency fund of three to six months of expenses first, then investing money you will not need for at least five years. If you have high-interest debt like credit card balances, paying that down usually makes more sense than investing, because the interest you pay exceeds what you are likely to earn.

Start with an amount you are comfortable with. Many people begin with $500 to $1,000 and add more each month. There is no minimum investment at most brokerages, so you can start with $50 if that is what you have.

Common mistakes to avoid

One mistake is buying too many different ETFs. If you own 15 ETFs that all track similar things, you are not spreading risk — you are just adding complexity. A simple portfolio might be one broad US stock ETF, one international stock ETF, and one bond ETF.

Another mistake is trading too often. Every time you buy or sell, you may trigger a taxable event in a regular account, and you pay the bid-ask spread (the difference between what buyers will pay and what sellers will accept). Frequent trading also means you are trying to time the market, which rarely works. Most investors do better by buying and holding for years.

A third mistake is chasing performance. An ETF that was the best performer last year is not may provide to be the best this year. Stick to a plan based on your goals and risk tolerance, not on what did well recently.

Frequently Asked Questions

Can I lose all my money investing in an ETF?

You can lose some of your money if the value of the holdings falls, but losing everything is extremely unlikely with a broad index ETF. An ETF tracking the S&P 500 would need all 500 companies to go bankrupt, which has never happened. Narrower ETFs — like those focused on a single sector or country — carry higher risk of large losses.

What is the difference between an ETF and a mutual fund?

Both hold a collection of securities, but ETFs trade like stocks during market hours at prices that change throughout the day, while mutual funds trade once per day after the market closes. ETFs typically have lower expense ratios and are more tax-efficient. Mutual funds may offer more active management, though index mutual funds work much like index ETFs.

Do I need a lot of money to start investing in ETFs?

No. Most brokerages have no minimum investment, and fractional shares mean you can invest any amount. You could invest $10 per week if you wanted to. The key is starting early so your money has time to grow.

Should I invest in individual stocks or ETFs?

ETFs are simpler and less risky for most people because they spread money across many companies. Individual stocks require more research and carry higher risk if you pick wrong. Many investors use both — a core holding in broad ETFs plus a smaller portion in individual stocks they research.

Can I hold ETFs in a retirement account?

Yes. You can buy ETFs in an IRA, 401(k), or other retirement account. In fact, this is a common strategy because the tax advantages of these accounts compound over decades. Check with your employer or retirement plan provider to see which ETFs are available in your specific account.