ETFs exchange-traded funds

Risky Business—Making the Most of Your Financial Investment

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.

3D image of stock prices along the side of a building with the word 'Diversify' shown

The Value of Diversity

Diversity is crucial in so many aspects of life: things are often improved when variety comes into the picture—backgrounds, perspectives, opinions, even diets. The same is true for investments. And if you’ve talked to an advisor before, you’ve probably heard about the importance of diversifying your holdings. But what does that actually mean? 

Those focused on buying and selling stocks may say it’s about having both value stocks and growth stocks in your portfolio. They may also counsel you on the merits of diversifying across market sectors—tech, financial, energy stocks, and more. Bond marketers may recommend that you acquire a diversity of bond types: government, corporate, mortgage-backed, and municipal. Those who earn a living selling structured products and annuities may encourage you to buy several kinds of their products—which certainly sweetens the deal for them, since they typically work on commission. But apart from the interests of professionals looking first and foremost to make a bigger profit, what’s real diversification? It’s about acquiring a mix of holdings that makes sense for your particular situation.

What does that look like? It’s often about having a properly allocated combination of large-, mid-, and small-cap domestic and foreign equities for long-term growth; bonds for potential income; and liquid assets—such as money markets, cash, and short-term treasuries—to meet more immediate expenses and income needs. With that kind of diversity, your money has the opportunity to grow, while remaining protected from significant shifts in the market. And as a result, when you need it—whether to cover the cost of a big expense, like a child’s college tuition or a new home; to fund your retirement; or to leave behind a legacy you can be proud of—it’s there. 

The key, though, is that your diverse portfolio is specifically tailored to fit your needs. Optimizing your investments can’t happen with a one-size-fits-all approach. There’s no way that, say, the standard balanced funds strategy (60 percent equities/40 percent bonds), can account for what exactly you need, when and how you need it. That’s why an experienced advisor who is actively managing your portfolio allocation can be invaluable. For more information on my approach, visit debrabrede.com.

Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.