What’s the best way to transition from stocks to index funds and ETFs?

I have read Paul Merriman’s book, Live It Up Without Outliving Your Money and watched some of Paul’s videos and listened to his podcasts. I have a question that hasn’t been addressed: What’s the best way to transition a portfolio from individual stocks to index funds and ETFs?

I would like to make the change quickly, but I’m worried that my timing might turn out to be all wrong. Should I do it all at once, or gradually over a period of time?

We believe that the move you are describing is a good way to reduce your risk and potentially improve your return, because index funds and ETFs will give you much greater diversification. I recommend you follow the recommendations that you’ll find in Paul Merriman’s article “The Ultimate Buy and Hold Strategy.”

Once you have made this decision, I cannot see any good reason to spread it out. If you do it all at once, you will get it over with quickly so you can focus on other things. I recommend you sell all the stocks in a single day. Stock trades typically take three business days to settle, so there will be a short delay before you can reinvest the proceeds.

During that brief period while your money is in cash, the market may go up or it may go down – or it could remain largely unchanged. You can’t control that, so you will have to accept it as an unknown price you’ll have to pay (if you must reinvest at higher prices) or an unknown bonus you receive (if you reinvest at lower prices). Either way, make the change and get it over with.

If you try to control this, you’ll have to predict or guess future stock prices, and that’s likely to lead to second-guessing your plan and not getting it accomplished.

There’s an exception to that advice. If the stocks you own are in a taxable account, it’s important that you consult your tax advisor before you move forward. Tax consequences in some cases should dictate the timing of your sales.

Are exchange-traded funds just derivatives in disguise?

I have tried to invest in all the asset classes you recommend, and mostly I am using ETFs. I hear so much these days about the dangers of derivatives that I wonder if that’s what ETFs are. I like what’s in them, but I know they are more complex than owning individual stocks, and I don’t understand exactly how they work. I don’t want to find out 20 years from now that I’m not holding anything real, only some kind of derivative that’s worthless.

You are correct that derivatives can be highly risky investments and should be used only by people who thoroughly understand them. Most exchange-traded funds are not derivatives; to understand that, you have to know what a derivative is.

A derivative is a contract between two parties who agree to take certain actions depending on what happens to the value of some underlying asset. The derivative does not represent ownership of the asset, only an agreement.

A share of stock, a share of a mutual fund and a share of an ETF that invests in stocks or bonds, on the other hand, represent ownership of a real asset.

One common example of a derivative is a futures contract that allows a farmer to lock in a price for a given quantity of a crop before harvesting the crop. The other party is someone who wants certainty about the cost of that crop at a specific time in the future. The contract lets both parties know what they can count on regardless of what happens to the market value of that crop in the interim.

Like mutual funds, most ETFs are baskets of securities, usually stocks or bonds, that let individual investors participate in the ownership of those securities. Unlike mutual funds, ETFs are traded on stock exchanges and can be bought and sold throughout a trading day at prices that are constantly changing to reflect supply and demand.

When you buy shares of an ETF, you are an indirect owner of that fund’s portfolio. You can sell or buy shares at any time. This gives them excellent liquidity.

Most ETFs and mutual funds do not utilize derivatives.   Both are relatively straightforward and inexpensive ways to own a large basket of securities. However, there are certain ETFs like those that invest in various commodities, which may gain their exposure through derivatives.