How would you like to invest your hard-earned money in something that could give you similar returns to stocks while reducing your portfolio’s volatility and risk? An investment that helped you achieve your desired asset allocation AND diversify at the same time? Welcome to Exchange Traded Funds (ETFs).
Even though ETFs trade very similar to individual stocks, they have several advantages that distinguish from their riskier cousins:
- Lower volatility
- Reduced risk
- Instant asset allocation
- Quick and cost-effective diversification
ETFs have less volatility than individual tocks
Volatility is simply how much your investment’s value changes – up over a certain time period (usually a short time period). It’s what keeps many investors lying awake at night! Investments with big and frequent swings in price have higher volatility than investments with gradual, incremental value changes.
Why the smaller swings? Even though ETF prices do change throughout the trading day, over the long term ETFs tend to have a lower volatility than individual stocks because they track an entire index of investments — and it’s relatively abnormal for the value of an entire index to go up or down more than a few percentage points in a day. On the other hand, the value of an individual stock can change dramatically based on who knows what. The CEO could be arrested for insider trading, news could break that the company is in trouble, or speculators could drive the price down for their own benefit. ETFs just don’t generally experience such volatility.
ETFs are less risky than individual stocks
Volatility is closely related to an investment’s risk – the possibility that an investment will lose it’s value. Volatility tends to track with risk, which in turn correlates with an investment’s return:
- The higher the volatility of an investment, the greater its risk and potential returns.
Though individual stocks offer the possibility of higher returns than lower-risk investments such as ETFs, they do so with much higher risk, especially in the short term.
ETFs make asset allocation easy
Various kinds of investments, such as stocks, bonds, cash, real estate, commodities, etc, are also called asset classes. Asset allocation is the process of determining how much of your investment portfolio you should put into each asset class. Once you’ve determined the asset allocation that suits you best, you can build a portfolio with that allocation by buying ETFs.
How do ETFs make asset allocation easier for the average investor? If you decide that your portfolio should contain 60% stocks, 30% bonds, and 10% commodities (a portfolio very similar to one in How A Second Grader Beats Wall Street), you can buy just three ETFs that track separate stock, bond, and commodities indexes. That way, you can avoid the hassle and expense of researching and buying various individual stocks, bonds, or commodities all while diversifying within those asset classes.
ETFs simplify diversification
Diversification means buying several types of investments within an asset class and can minimize your investment risk without sacrificing your returns over the long term. Since ETFs track the performance of an entire index of investments, they allow you to diversify easily and cost-effectively. Why? With just a few ETFs, you can own a small slice of hundreds or even thousands of different types of stocks, bonds, and other investments. Attempting to build a diversified portfolio by buying individual investments, is much more risky, time-consuming, and costly than diversifying with ETFs. Just the cost alone of buying 2,000 individual stocks would cost an enormous amount of money!
Diversification with ETFs
Rather than own just one ETF in each of the various asset classes of your portfolio, you can further diversify by owning several different stock ETFs, bond ETFs, and so on. For example, if you intend to allocate 60% of your portfolio to stocks, you could buy one ETF that tracks an index of the entire United States stock market, such as Vanguard’s Total Stock Market ETF (symbol: VTI) or iShares Dow Jones U.S. Index (symbol: IYY). A better idea, however, might be to spread out your 60% stock allocation among various other types of stocks, such as international stocks. That way, if the U.S. market experiences a sudden decline, your entire stock allocation won’t necessarily experience a similar plunge in value.
For individual investors, ETFs beat stocks hands down
Are you invested in any ETFs? What are your thoughts?