ETFs can be safe yet powerful investments. But there are still risks involved.
Investing in the stock market is one of the most effective ways to generate wealth over time, but buying individual stocks can be risky and time-consuming.
This strategy often requires loads of research, as you’ll need to study the fundamentals of each company you’re interested in buying — from the business’s financials to its leadership team to how it stacks up against competitors in its industry. Then you’ll need to do that a couple dozen more times, as a well-diversified portfolio should ideally contain at least 25 to 30 stocks.
Investing in an exchange-traded fund (ETF) can be a much simpler way to buy. Each ETF contains a variety of stocks, and by owning just one share of an ETF, you’ll instantly own a stake in every company within the fund. This can make it nearly effortless to build a diversified portfolio with far less research.
While ETFs can sometimes be safer than individual stocks, there are still risks involved — and it’s possible to lose money with even the safest investment if you don’t have the right strategy. Here are three things to know.
1. All ETFs are different — and that will impact your risk potential
Not all ETFs are created equal, and some are riskier than others. Some ETFs may contain hundreds of large stocks from a wide variety of industries, while others may only include a couple dozen small stocks in one very niche sector of the market.
For example, at the broadest level, you may have a fund like the Vanguard Total Stock Market ETF — which contains 3,656 stocks across all sectors of the stock market. Or you could opt for a more targeted fund like the Vanguard Health Care ETF, containing 419 stocks only within the healthcare industry. For an extremely niche option, you could also invest in a fund like the iShares U.S. Medical Devices ETF — which contains only 48 stocks from U.S. companies that create and distribute medical devices.
All of these types of ETFs can be smart investments, but smaller, more niche funds carry more risk than broad-market funds. If you’re going to invest in a more specific type of ETF, it’s wise to ensure the rest of your portfolio is well diversified to protect your money as much as possible.
2. You could always experience short-term losses in value
When investing in the stock market, it’s important to distinguish between losing money and losing value. Your investment can lose value if its share price falls below your purchase price, but that doesn’t necessarily mean you’ll lose money.
For example, say you buy one share of the Vanguard S&P 500 ETF (VOO -0.20%), which is currently priced at around $525 per share. Let’s also say that, theoretically, the market takes a turn for the worse later this year and this ETF drops down to $475 per share.
In this scenario, your investment would have lost $50 in value. But as long as you don’t sell your share, you won’t have technically lost any money.
Then say, for example, the market surges again, and this ETF jumps to $550 per share. If you sell at that point, you’ll have made a $25 profit — even though your investment temporarily lost value in the meantime.
In this regard, investing in ETFs is no different than investing in stocks. The market will always be shaky over weeks and months, and sometimes it can experience prolonged bear markets that last years. However, although your investment may lose value in the near term, you won’t actually lose any money unless you sell during those dips.
3. A long-term outlook is key with any investment
In general, the longer you hold your investment, the more likely you are to earn positive total returns.
When investing in an S&P 500 fund, holding your investment for one year carries a 27% chance of seeing negative returns, according to a study from investment firm Capital Group. However, after five years, that chance drops down to 12%. Hold your fund for 10 years, and there’s only a 6% chance you’ll earn negative returns.
Ideally, it’s best to hold your ETF for at least several years or even decades to minimize potential losses. Again, the market will always experience short-term ups and downs. Generally, though, the longer you hold your investments, the less likely you are to lose money.
Investing in ETFs can be a smart way to build wealth with less effort than buying individual stocks. While no investment is risk-free and it is still possible to lose money with an ETF, the right strategy can better protect your savings.