Are ETFs safer than stocks?
It’s a question that many investors have probably asked themselves as they begin to manage their own money.
As with so many things on Wall Street, there is no definitive answer here. There is a huge universe of exchange-traded funds out there that tops more than 7,000 worldwide at present, and just like stocks, these investments can vary widely. And beyond that, the same ETF can perform very differently from one investor to another depending on their personal goals and trading habits.
In short, the answer to the question of whether ETFs are safer than stocks is a rather unsatisfying “it depends.”
That said, if you’re truly interested in diversified, ” buy and hold” investing over the long term — and most small, individual investors should be — then ETFs could be safer than stocks in some important ways. It should go without saying that investors must always do their own research and think carefully of their individualized goals before making any trade, but here are a few general reasons why you may want to consider ETFs over stocks if you’re looking to reduce your risk profile:
— ETFs can be diversified.
— ETFs can be affordable.
— Index ETFs outperform active managers.
— When ETFs are not safer than stocks.
ETFs Can Be Diversified
When you buy a stock, you’re buying a specific company with a specific business model. However, ETFs are comprised of many components that allow for built-in diversification.
Consider the landmark SPDR S&P 500 ETF Trust (ticker: SPY) that has a staggering $360 billion in assets under management and is one of the most popular exchange-traded funds on the planet. As the name implies, this ETF is benchmarked to the S&P 500 index that is comprised of the 500 largest U.S. stocks — such as Apple ( AAPL), Tesla ( TSLA) and JPMorgan Chase & Co. ( JPM). If you want to avoid putting all your eggs in one basket, then this is a very easy way to build an inherently diversified portfolio without complexity.
ETFs Can Be Affordable
In the past, relying on someone else to build this kind of diversified portfolio for you came with steep management fees. But certain ETFs provide investors with access to these investing strategies at very affordable prices. According to FactSet, asset management giant Vanguard boasted an asset-weighted expense ratio of 0.06% in 2020, while State Street’s SPDR family was 0.14% and BlackRock’s iShares family of funds was 0.19%.
In case you can’t do the math in your head, this means the typical ETF from these providers ranges between $6 and $19 annually on every $10,000 you have invested. Decades ago, small-time investors used to pay many times that amount in fees. Since every penny saved on costs today is a penny earned in interest or capital gains down the road, this is a tremendous benefit to many investors that can reduce risk and amplify returns over the long term.
Index ETFs Outperform Active Managers
Many on Wall Street would have you believe that you are better off paying expensive fees for their elite services. The fact is, a simple approach that reduces fees and simply follows a diversified index like the S&P 500 consistently outperforms fancy ” active management” styles where a manager picks and chooses stocks, such as with mutual funds. Consider that even in 2020, a year with many unseen challenges caused by COVID-19, 57% of active funds underperformed broad stock market indexes, according to the S&P Indices Versus Active (SPIVA) Scorecard.
Sure, a few individual stocks can surge in short order and dwarf the profits generated by an index fund. And yes, some managers are either lucky enough or shrewd enough to identify them. The truth is “passive” investing using index funds has consistently outperformed “active” managers every year for the last decade. If you think you can overcome this trend by picking individual stocks or trusting a high-priced manager to pick them for you, these hard facts should give you pause.
When ETFs Are Not Safer Than Stocks
All of these points lean together in that an individual investor who buys and holds affordable index ETFs for the long term will probably see better returns and a lower risk profile than if they hand-pick individual stocks on their own.
However, a few ETFs exist that are not only imperfect ways to follow this advice but are actually the polar opposite of this strategy. These include:
— Focused ETFs: There are some funds that specifically avoid diversification and keep a very short list of investments.
— Active ETFs: There are some ETFs that are not benchmarked to a passive index but instead rely on a team of “experts” to build the portfolio. Often they can also have very high turnover rates, meaning the fund buys and sells positions frequently.
— Leveraged ETFs: These are funds that use sophisticated financial instruments to try and deliver twice or three times the returns of an underlying index. Obviously this is nice when things swing in your favor, but it’s very risky to be on the wrong side of the trade.
— Overpriced ETFs: Any and all of these more complex strategies often carry with them much higher fees.
There is no one-size-fits-all approach to exchange-traded funds, just as there is no universally correct way to invest. In the end, it all boils down to your personal goals, risk tolerance and financial situation. And even when you know what you’re trying to achieve, the old adage “buyer beware” is crucial to follow before you add any investment to your portfolio.
Even so, it’s undeniable that investors who pursue diversified, long-term investments should consider many ETFs safer than stocks for this purpose.
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