Are ETFs safe to invest in? What are the risks?

Are ETFs safe to invest in?

All investments carry risks, but exchange traded funds are viewed as a safer investment than individual stocks. ETFs provide a higher level of diversification than individual stocks, but might carry high fees or low liquidity. Investors should do their due diligence to understand the ETFs investment style and risk factors prior to investing.

Imagine, investing with confidence and knowing that your ETF was a good choice. You have a well diversified portfolio and can sleep easy at night.

ETF investing is a good way to invest with minimal thinking!

Luckily for you, I’m going to show you if ETFs are safe to invest in and what are possible risks. I’ll even give you some tips to safely buy your first ETF or help you decide if stock investing is better.

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Are ETFs safe to invest in?

Exchange traded funds are typically considered a safe investment, but all investments carry risks. ETFs are ideal because they provide a good level of diversification and ease of investing. The primary risk comes from not knowing what you’re investing in. Therefore, take time to educate yourself before investing.

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What are the risks of ETFs?

The main risks of ETF investing include lack of investment knowledge, high fees, and low liquidity. Investors should carefully research exchange traded funds prior to investing to minimize risks.

Each ETF has an overlying goal and a fee structure. You need to be aware of how each goal fits into your investment strategy and evaluate fees.

Additionally, each ETF is only traded so many times each day. The more trades, the higher the liquidity or your ability to sell at a moment’s notice. Too little liquidity and you might not be able to sell your shares.

Let’s take a look at each of the risks.

Not knowing what you’re investing in

Investor knowledge is the biggest problem when it comes to investing. Investing isn’t taught in schools, which leads novice investors to making bad choices. You need to be able to properly evaluate each ETF prior to investing.

There are different types of ETFs, each having a different goal. You need to understand what the goal of the ETF is prior to investing.

For example, a growth ETF is focused on rapidly growing companies. Rapidly growing companies tend to see more rapid share price increases. Value ETFs focus on undervalued companies where the share price doesn’t reflect the value of the company.

A value investor is thinking the share price of the company will eventually catch up. Growth investors are investing in new, innovative companies, and expecting big earnings.

All ETFs can be broken down even further into small, mid, and large-cap funds. Capitalization basically means how much the overall company is valued. Small-cap companies are worth less than large-cap.

Both growth and value investing are considered a safer investment choice.

However, other ETFs exist which may increase the risk of your overall investment. For example, you might come across leveraged ETFs, Sector Specific, and other low-diversification funds.

Leveraged ETFs borrow money to try and boost earnings. For example, a 2x S&P 500 index ETF might return double the gains of the S&P 500. Alternatively, you could lose 2x the losses of the S&P 500.

Sector specific ETFs have a lower level of diversification because you’re investing in one asset class. For example, a real estate ETF would only be investing in real estate. Therefore, you can expect this ETF to get hard if real estate doesn’t do well.

High Fees

Over time, ETF fees can add up. The lower the ETF fees, the more money you’ll have in your pocket at retirement. I’m not talking about one to two thousand dollars, I’m talking $100k or more.

For example, you might want to invest in an S&P 500 fund. ETF fees vary between 0.03% all the way up to over 1% depending on the brokerage firm. Each fund tracks the same index, but charges substantially different fees for the same product.

Let’s take a look at two S&P 500 funds. One charges an expense ratio of 0.03% while the other charges 1%.

You start out with $10,000 invested and can contribute $5k per year. Here’s the performance of each fund over the course of 30 years at 10% return on investment:

S&P 500 fund charging 0.03% S&P 500 fund charging 1%

Total Portfolio Value

$1,079,211.15

How much did you keep?

$1,072,421.28

$875,552.87

How much did you pay in fees?

$6,789.87

$203,658.28

Cost difference

$196,868.41

You would spend almost $200k in extra fees by choosing the wrong S&P 500 fund.

Low Liquidity

Volume is an important term you should know when it comes to investing. Volume is the number of trades per day of a security, like an ETF. Low volume may be a sign of low liquidity or it being hard to sell your shares when needed.

Basically, there’s low demand of people buying or selling shares.

You might try and sell multiple shares of a low volume ETF or stock. However, due to low demand, your brokerage might only be able to sell a few shares at a time. Therefore, it might take a while to fully sell off your shares.

You should always verify the ETF you want to invest in has a decent level of volume.

Can you lose all your money in an ETF?

All investments carry risks, including the complete loss of investment. In most cases, smart investing can help eliminate the risk of investment loss. Leveraged ETFs have a higher likelihood of a complete loss of investment.

Double and Triple leveraged ETFs work by borrowing debt to increase investment gains or losses. For example, investing in a triple leveraged ETF would return 30% gains if the underlying index returned 10%

UPRO is a triple leveraged S&P 500 index fund. Should the S&P 500 drop 33% in one day, you could lose all of your investment as UPRO would drop 99%.

However, a 33% drop is unlikely. The largest the S&P 500 has fallen in one day has been 20.47%.

The stock market has implemented ‘circuit breakers’ or certain percentages at which the S&P can drop before trading is halted. There is a 15 minute trading halt when the S&P 500 declines by 7% and 13% from the previous close. At a 20% decline, trading halts for the remainder of the day.

Should I buy an ETF or Stock?

Invest in ETFs if you want a well diversified portfolio which requires minimal thought process. However, individual stock investing is more complex, but can lead to larger gains or losses. ETFs are better for passive investors who want to minimize risks.

At the end of the day, you have to look at your investment style. Do you want to constantly monitor your portfolio to make sure individual stocks are performing? Or, would you rather buy, hold, and relax as your money grows?

ETFs are perfect for individuals who can’t keep up with the stock market every day. You don’t need a lot of stock market education to invest in ETFs because they’re simple investments.

Individual stocks require you to be able to read balance sheets and make informed decisions. Picking individual stocks can be time consuming.

How to safely buy an ETF

Safely buy ETFs by choosing good low-cost ETFs like an S&P 500 index fund. Make sure you educate yourself on investing and choose an investment professional if you’re unsure. Don’t invest your money into anything you are not sure about.

The S&P 500 is one of the best choices for new investors. Even Warren Buffet recommends the S&P 500 for buy and hold investors.

Take time to educate yourself if you want to be an investor. Knowledge is the best resource you have for picking individual stocks or ETFs. Simply knowing what you’re investing in can resolve the majority of problems investors have.

At the end of the day, you can always hire a professional to manage your money for you. However, not all investment professionals are the same. Make sure you shop around.

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Summary: Are ETFs safe to invest in?

As you can see, ETFs are typically considered a safe investment. However, you should educate yourself on the subject before investing your money. Always seek to understand the underlying goal of the ETF and make sure your assets are diversified.

The biggest problems with ETF investing come down to investor knowledge, fees, and liquidity. Again, being a knowledgeable investor would resolve the majority of your problems.

Technically, you can lose all of your money investing, especially in triple leveraged ETFs. However, it is unlikely that such an event would happen. Avoid risky ETFs and make sure you are well informed before investing.

Always consult a professional if you are unsure of your investments. A good professional can help you build long term wealth.