Individual stocks go up and down but most of the major stock markets they inhabit rise higher in the long run - at least for the past 50 years.
Indices including the S&P 500 and S&P/TSX have weathered natural disasters, wars, pandemics, a global financial meltdown and even Donald Trump.
Whether they continue to rise over the next 50 years is not guaranteed but there’s a very good chance they will thanks to their ability to shift with changing market values.
That’s why investing in one of the major exchanges through a market cap-weighted index exchange trade fund (ETF) right now could be the reward the present you gives to the future you.
How index ETFs work
Index ETFs generally track market cap-weighted indices from major geographic regions, sectors and sub-sectors.
The company stocks that trade in the index are sized by their total market value, known as capitalization.
If a stock in the underlying index gains in value, it takes a bigger stake in the index and consequently, the ETF. If it declines, the stock moves down the ranks and possibly out of the index. In other words, the cream rises to the top and the weak wither.
As an example, Nvidia has risen to the largest weighting in any market weighted ETF that tracks the Nasdaq 100 (12.9 per cent), ahead of Apple (11.3 per cent) and Microsoft (7.8 per cent). As Nvidia shares rose in value over the past 5 years it overtook the so-called “FAANG” stocks including Amazon, Meta (Facebook) and Alphabet (Google), and helped propel the value of the entire index by nearly 80 per cent.
Remove the guess work by buying the entire index
Few professional investors knew AI-based stocks like Nvidia would take off the way they have, let alone retail investors saving for retirement. But it doesn’t matter because market weighted ETFs remove the guess work for up-and-coming trends.
If you own the index, you automatically own a bigger piece of the hottest stocks and a smaller portion of the weak stocks.
If you bought a Nasdaq 100 ETF in the wake of the 2000 tech meltdown, for example, you were invested in the technology heavyweights of the day like Palm Inc., Red Hat, JDS Uniphase and Canada’s Research in Motion (now Blackberry).
If you held it to 2019, those companies had long faded from the upper ranks of the correlating index to make way for what became the FAANG stocks.
As companies came and went since the tech-wreck of 2000, the value of the Nasdaq 100 has ballooned by more 25,000 per cent.
Position your portfolio for up-and-comers in other sectors
While the Nasdaq is often considered a technology index, only 60 per cent of its components are actually technology stocks. There are countless other market-weighted ETFs with a pure focus on specific sectors such as health care, or sub-sectors including biotech, genomics and pharmaceuticals.
One example is the VanEck Pharma ETF, which has risen 44 per cent over the past 5 years and more than quadrupled since 2009 on advances in drug development.
Top holdings include global pharmaceutical giants Eli Lilly & Co., Novartis AG and Merck & Company.
It also holds Novo Nordisk, the maker of diabetes drug Ozempic, which surprised markets by also being an effective treatment for obesity.
Even multi-billion dollar money managers often resort to health-care ETFs to hedge against risk from the unpredictability of the effectiveness of a company’s single product or regulatory approval.
Be ready for anything with an ETF portfolio
Investors who choose ETFs over individual stocks will never get the full benefit of the next Nvidia or Novo Nordisk but they will be protected by the full downside impact of companies that flame out. Diversification is key for retirement investors who want to hold on to their gains.
Total diversification is possible through a portfolio of ETFs that span all major sectors and geographic regions.
Investors can add to their positions on market dips or dollar-cost-average by making regular contributions through their trading accounts.
It is important to know ETFs charge annual fees based on a per cent of the amount invested, which causes them to lag the performance of the underlying index depending on the fee.
Fees can be lower than one-tenth of a per cent but can top half of a per cent if the ETF is Canadian dollar hedged. That’s why it’s wise for Canadian investors to invest using U.S. dollars.
U.S. dollar trading accounts are permitted in registered retirement savings plans (RRSPs) and tax free savings accounts (TFSAs).
