ETF: Why time matters most

Investment decisions are overwhelming. In this post we are going to talk about the one question that removes a lot of the anxiety around investing: when do I need to take the money out of the market?

If your own research lead you to index investing and ETFs, it probably took a while to understand how exactly they work. Maybe you’re not quite clear on that yet – don’t worry, it will come. There are almost 80 different ETFs to choose from in the South African market. If you’re starting out, you probably have some fears over which one should you pick.

We’ve written some articles on assets classes, methodology and costs to help you choose an ETF that makes sense to you. However, you will probably make better overall financial decisions if you understand the role of time in your investment life.

You need to worry about time first

The sooner you start investing, the more time you have for your investments to compound. ETF investments compound in two ways.

Firstly, the dividends paid by the companies in which the ETF is invested get paid out to ETF unit holders. Dividends get paid out as cash into your investment account (unless you’re invested in a total return ETF, which invests your dividends back into the ETF on your behalf). When you use that cash to buy more ETF units or shares, the new units or shares will earn dividends the next time around. You don’t have to reinvest your dividends into the same ETF that paid them. You can invest them anywhere or even draw them and use the cash.

Secondly, the price of the ETF unit rises over time by at least inflation. That’s because the companies who charge more money for the same products we bought last year are the same companies in which the ETF invests. The rising share prices of the companies in which the ETF is invested affects the unit price of the ETF. Over time, that price goes up and up, creating a compounding effect on the growth of the ETF’s performance.

When the share prices of all the companies in a market go up, the entire market goes up. This is the principle upon which index investing is based. Over a short period of time, like a month or a year, company share prices go up and down a lot. That’s because there are people buying and selling the shares to make short-term profit. Sometimes external events, like political instability, affect how many people want to buy shares. If more people want to buy a share, the price goes up. If more people want to sell a share, the price goes down. Since the price of an ETF unit is based on the price of the underlying shares, the price of an ETF unit also reflects this price instability in the short term. However, over time the prices of companies represent what the market thinks the company is worth. Profitable, stable companies have rising share prices over time. This, in turn, raises the price of the ETF. Poor companies whose share prices fall, or companies that fail, fall out of the ETF.

Time is your most important asset, because the longer you stay invested, the more opportunities you have to receive dividends to buy more units. The longer you wait to cash in your investment, the more time your ETF share price has to go up.

You need different assets

Shares behave differently than property companies, bonds or cash. A world event can have an impact on the success or failure of a certain type of company, while bonds promise and deliver a set return over time regardless of what happens in the world. How these different assets respond to market movements over time is an important consideration when putting together a portfolio.

Your investments should change over time

As you get closer to cashing in your investments, your portfolio needs to change. You don’t want to have all your money in shares a year before you need to cash out of the market. If the market is down, you’ll have to wait or sell your ETF units at a lower price than you paid for them. As you get closer to needing to use your money, you should start making choices about where that money goes.

Once again, the impact of time on these choices shouldn’t be underestimated. Start the process of choosing your next investment by asking, “When do I need to take the money out of the market?”