Risks of ETFs

Everybody knows it’s hard to beat the market over long periods. Fewer investors recognize that it’s easy to do a lot worse than the market. It’s especially easy if you fall for every new investment innovation that comes along.

Exchange-traded funds (ETFs) are an investment innovation that has advantages over some alternatives, but can still lead to steep losses. ETFs give you a low-cost way to invest in a narrow market segment. That’s cheaper than investing in a mutual fund with a similar focus. ETFs may cost you 0.5% a year, compared to 2% to 3% or higher on a fund.

ETFs are also safer than investing in just one or two stocks from the area you are interested in. ETFs spread your money around over dozens, if not 50 or more, stocks.

However, ETFs make it all too easy to jump into a narrow market area at just the wrong moment. They can lead you to build a portfolio of whatever is currently “hot” in the stock market: China, oil, solar power, agricultural investments, gold or whatever. But investments only turn hot after a lot of the profit has been made. If you stuff your portfolio with “hot” investments, you’re apt to have tepid results, at best.

Worse, when you focus on what’s hot, you tend to lose sight of investment quality and diversification. In the long run, that virtually guarantees poor results, if not deep losses.