We all approach investing with the goal of growing our wealth. And we know that achieving that growth comes with risks. But there’s a difference between taking on a reasonable amount of risk and stepping into a bear trap because you failed to read or didn’t understand the fine print. To highlight the impact of misunderstanding the vehicles in which you invest, let’s take a look at one popular product: ETFs, or exchange-traded funds.
An exchange-traded fund (ETF) is a marketable security that tracks a stock index, bonds, or a set of assets. ETFs trade like a common stock on a stock exchange and experience price changes throughout the trading day as they are bought and sold.
And while computers and algorithms can accomplish some pretty amazing things, there are many ways in which they fall short—and dial up risk—when it comes to your hard-earned money. To see why, let’s dig a bit deeper into how ETFs work.
Most index-based ETFs are weighted by capitalizations, or the size of the companies in the index they mirror. Those companies with the largest market caps carry the heaviest weighting. As such, as those companies’ stock prices increase, their weighting within the index tracked by a particular ETF increases too. As a result, just a few companies can account for a large percentage of an index’s weighting (think Apple, Google, Facebook, and the like). That concentrated stock position exposes an investor to more risk. Why? Any bad news about one of those heavily weighted companies will also weigh heavily on that ETF’s earnings.
And because index ETFs are passively managed, those holdings only change as their capitalizations change—which requires a significant drop in a company’s revenues, and thus in stock price (and capitalizations), or bankruptcy. We can look to market crashes to see the potential damage of passive management; just think about the tech bubble correction of 2000, and the blows suffered by leading tech companies (which composed a large portion of the S&P 500)—and their investors.
Meanwhile, active managers have a lot more control. They can choose to sell off a portion or all of a stock holding at any time, meaning an investor isn’t locked into a particular holding if things begin to sour—or if they seem too good to be true.
Of course, active managers aren’t infallible. We all make mistakes. But those with experience have a solid chance of growing wealth while minimizing risk. Ask yourself, “Is it time to invest in an expert?”
An exchange-traded fund (ETF) is similar to a mutual fund that tracks a specific stock or bond index, such as the Barclays Capital 1–3 Year Treasury Index. ETFs trade on one of the major stock markets and can be bought and sold throughout the trading day, like a stock, at the current market price. And, like stock investing, ETF investing involves principal risk—the chance that you won’t get all the money back that you originally invested—market risk, underlying securities risk, and secondary market price.