Investors have a lot of choice when it comes to choosing what to invest in. Popular choices include stocks, which offer them a share of ownership in a company, and funds, such as exchange-traded funds (ETFs) – which hold a portfolio of stocks, bonds and other such commodities that are traded on an exchange, and allow them access virtually every corner of the global financial market.
However, all investments carry risk, so it is important to analyse the safety of each investment vehicle before diving in head first.
- What makes an investment safe?
- The key characteristics of low-risk investments: how do stocks and ETFs compare?
- So, are ETFs safer than stocks?
What makes an investment safe?
It’s almost impossible to pick one investment that is considered ‘the safest’, given the range of possibilities in the market and the volatility of the economic climate, and nothing is completely ‘risk-free’ when it comes to investing.
Investing involves putting money into something – usually some kind of financial asset – in the hopes of making a profit. You just have to remember that there are two sides of the investing coin: risk and reward. There is always a possibility to experience losses when there’s a possibility of experiencing gains, too.
Not all investments are made equal in terms of risk. Some investments come with extremely minimal chances of losing your money.
Although there is no universal definition for “low-risk,” low-risk investments do share some key characteristics. They’re usually well-diversified, less volatile, hold onto their value over time, experience fewer price swings, and have high liquidity – meaning they’re easy to convert into cash.
Purchasing power is another important factor to consider regarding the safety of an investment. When you opt to make a safe investment, it generally indicates that your primary investing goal is to protect your principal, even if this means that you will receive less profit or growth. However, be aware that if you don’t earn enough interest, your purchasing power might actually erode over time.
For instance, while your principal might be protected, if your safe investment earns 3% a year and inflation is 5% a year, your money will not go as far as it used to.
A lot of people believe that the greatest risk is losing principal. But, if you have a long-time horizon, the erosion of purchasing power caused by inflation can be just as unsafe.
The key characteristics of low-risk investments: how do stocks and ETFs compare?
Let’s compare the safety of two of the most popular investment vehicles: Stocks and ETFs.
First, consider their similarities:
Both are traded on a stock exchange. Because they are widely available and traded in high volumes throughout the day, they are easy to buy and sell and generally have a lot of liquidity and transparency.
Transaction fees. Both are readily available through online brokerages because they trade easily on the stock exchange. These platforms are increasingly reducing the cost of their fees, which removes barriers for individual investors looking to diversify their portfolios with stocks and ETFs.
Both provide a wide range of investment opportunities. Stocks and ETFs can both be used to invest in a broad range of markets, industries, businesses, and more.
Dividends. Many companies pay dividends to shareholders, which represent a portion of the company’s profits. Some ETFs also distribute dividends from the stocks they hold, which are paid out to ETF shareholders. You can read more about dividends here.
Looking at a company’s dividend history is a good way to gauge its long-term stability. It’s a good sign if a company’s dividend has seldom (or never) been slashed and has a track record of rising pay-outs, even in difficult times.
Now consider three key factors that impact the safety of an investment:
Diversification
When investing, try to refrain from putting all your eggs into one basket. If it’s individual stocks you want to invest in, you can limit your risk by investing in at least ten to fifteen different companies. This is the only way to gain significant diversification with stocks. However, this can get expensive over time, and your portfolio could still suffer if even one or two of those stocks underperform.
ETFs, on the other hand, are available for practically every asset class in the financial world, including many low-risk investments. Examples include Treasury bonds, blue-chip stocks, and AAA corporate bonds.
Because ETFs allow you to invest in dozens or even hundreds of assets without having to break the bank, even if a few of the assets in your ETF plummet, it’s unlikely to have a big impact on your overall portfolio. This means diversifying your portfolio with ETFs will also be less expensive than if you bought those same stocks separately.
However, in the case of unexpected events or the rare case that the whole stock market goes south, otherwise known as a ‘black swan’ event, make sure your ETF portfolio doesn’t consist of just stocks. Include bonds and other such asset classes to create a robust ETF portfolio. This leads us onto volatility.
Volatility
Individual stocks are often considered a higher-risk investment because of the possibility of substantial price swings and significant losses if things go wrong for the company. That said, stocks can generate very impressive gains if you buy into the right company, which might protect your purchasing power in the long run.
On the other hand, because ETFs benefit from built-in diversification and the value of a collection of companies is less likely to fluctuate, they are generally considered less volatile than stocks. Just note that because you’re investing in a collection of companies, you’re buying both losers and winners, which means the end result averages out and prospective profits can be restricted.
Ability to maintain their value in the long-term
ETFs often track stock market indexes, such as the Dow Jones Industrial Average or S&P 500; because the indexes themselves have always managed to rebound from previous market crashes, ETFs can be considered among the safest investments available.
The stock market can experience high volatility in the short term, but indexes generally experience positive long-term returns. ETFs are therefore very likely to rebound from even the harshest market crashes because they track the market.
The truth is that a simple approach that cuts down on fees and follows a diversified index like the S&P 500 often outperforms actively managed stock picking.
While both investments carry some risk, diversified ETFs appear to have the potential to outperform over time. However, there are a few ETFs out there to be wary of. These include:
Focused ETFs: These funds don’t diversify and keep their portfolios to a bare minimum. This naturally increases their risk because they hold a limited number of stocks and sectors that are similar.
Leveraged ETFs: These are funds that attempt to generate twice or three times the profit of an underlying index by employing advanced financial instruments. While it’s great when things are going your way, being on the wrong side of the trade is obviously quite dangerous.
Active ETFs: These ETFs aren’t benchmarked to a passive index; rather, they are relying on a team of experts to put the portfolio together. They usually have high turnover rates, which means the fund buys and sells holdings on a regular basis.
So, are ETFs safer than stocks?
There is no one “correct” or “safest” method in investing, especially when it comes to ETFs and stocks, as there are so many factors to consider. It all comes down to your personal objectives, risk tolerance, and financial circumstances. Even if you know what you want to achieve, you should always keep in mind that past rewards don’t guarantee future rewards before adding any investment to your portfolio.
Even still, it’s apparent that diversified, long-term investment strategies have a tendency to perform well, and many ETFs are safer than stocks for this reason. It’s also worth emphasizing that ETFs make more sense for some investors, such as newbies and those who haven’t yet gained a lot of knowledge, because many investors don’t know how to beat the market.
If you want to invest safely in stocks, look for companies with a consistent increase in revenue year after year. Erratic returns tend to follow erratic stock prices, whereas consistent returns are more common among stocks with low volatility.
As previously mentioned, no stock is fully immune to market volatility and competition, so by investing in relatively stable stocks and spreading your money over a number of them provides far more protection than buying just one or two.
Even the most well-run businesses are subject to short-term pricing fluctuations, as evidenced by the COVID-19 pandemic. Don’t be concerned with short term stock price fluctuations; instead, concentrate on companies that are most likely to perform well in the long run.
Essentially, finding stable companies, buying a large amount of their stock, and holding on for the long term is the best recipe for safe stock investing.
Ultimately, keep in mind that you are not obligated to choose just one. Indeed, a portfolio of stocks, ETFs, and other assets may be the key to a well-diversified investment portfolio for many investors.
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