Note: This article is a continuation of ETFs Vs Unit Trusts: Which is better
You may have heard or read about Exchange-Traded Funds (ETFs) while learning about investing for the first time. Compared to purchasing individual stocks and bonds, ETFs come with the benefit of being diversified in nature.
Being diversified, ETFs are notably “less risky” for beginner investors compared to other investments such as stocks and derivatives.
However, does this mean that ETFs are risk-free? Let’s find out.
Disclaimer: All investment opinions made in this article are based on personal experiences and are meant for informational purposes only. Information from this article should neither be taken as investment advice, nor as a substitute for financial advice provided by a professional. While we strive to provide accurate and up-to-date information, engaging in any investments will be at your own risk.
Firstly, let’s look into what it means for an ETF to be diversified.
According to the definition on Investopedia, ETFs involve a collection of securities that track an underlying index.
These securities may refer to a variety of assets, including, and not limited to stocks, bonds, commodities (such as oil/gold) and other complex financial instruments (such as derivatives).
In an ETF, the fund manager adds various securities into the fund to reduce concentration risk.
Concentration risk is simply a fancy way for fund managers to describe putting all of your eggs in one basket. By diversifying the ETF’s holdings, concentration risk is reduced, reducing the likelihood of investors seeing large fluctuations in the value of their portfolio.
I’ll use a recent example to illustrate; in 2020, the emergence and rampant spread of the Covid-19 virus had caused panic in the financial markets across the globe, causing the prices of assets to fall to market lows around the end of March.
Scenario 1: Putting all your money into a single asset:
Hypothetically, if you had bought DBS Stock (SGX:DO5) at the beginning of 2020, when it was a price of $26.11, your portfolio would have lost 36% by the 23rd of March when the stock price crashed.
Scenario 2: Buying a diversified ETF:
Alternatively, if you had bought the Nikko AM STI ETF (SGX:G3B.SI), you would have instead lost 30% over the same time period.
Due to the diversified nature of the STI ETF, which holds various stocks of companies spread across different sectors, the decline in its value was less than if you had bought into scenario one instead.
Note that the example I used above is relatively extreme, as such large falls in market price do not occur very often.
Another way to view diversification is to consider a scenario in which a company fails. For instance, if DBS Bank were to go bankrupt suddenly, you might lose your entire investment. However, if you were holding on to the STI ETF instead, you would still have most of your investment as only 14% of its holdings is actually DBS Bank.
Remember, in investing, it’s not about “going big or going home”, rather, it’s about building up a consistent holding over a long period of time.
Markets go and up and down all the time. As a result, the value of one’s holdings will change continuously on a day-to-day basis.
In the example above, the STI had lost close to 30% over the first few months of the year.
However, this does not mean that you have permanently lost 30% of your money. Instead, this 30% loss is simply a paper loss, which is not equivalent to realized losses.
So long as you stay invested and avoid redeeming your holdings, you will be able to wait for the market prices to recover.
As seen in my previous example, ETFs are not immune to market risks. If events such as the 2008 financial crisis—or more recently Covid-19—occur, there are bound to be significant market downturns.
This brings up the point of the importance of having emergency savings. It would be pertinent to have at least six months of emergency expenses saved up in a bank account before investing, which you can readily tap on should emergencies arise.
With this emergency savings account, you would not need to consider withdrawing your investments at market lows and realizing your losses.
ETFs trade on an exchange, similar to stocks and bonds. As a result, each transaction will be associated with a trading cost, which is usually quite significant if you are buying in small sums. For instance, if you were to buy one lot of an ETF at a total price of $250, at a trading fee of $25, you would already have lost 10% of your initial investment.
It is therefore important to be aware of the significance of such fees, as they will eat away at your investment without you realizing it.
Instead, you could consider Regular Savings Plans. These are often offered by financial institutions such as FSMone or DBS bank, and enable investors to dollar-cost average their investments while keeping transaction costs significantly lower.
Dollar-cost averaging refers to the investment technique in a fixed sum of money is used to buy ETFs at regular intervals (usually once a month). This enables investors to buy more units when prices are low, and fewer units when prices are high. This, in effect, averages the market price fluctuations, which removes the need for market timing.
For more information on the types of RSPs available in Singapore, this article by seedly.sg compares between the cheapest RSPs between different financial institutions.
So, what does this all mean for me?
Okay, so we have established the fact that ETFs come with their own sets of risks.
Does this mean that ETFs should be avoided? Definitely not.
There are bound to be risks in anything you do in life; what matters is how you deal with them. For instance, driving a car would involve the risk of getting into an accident, but this shouldn’t deter one from driving. Rather, risks can be managed by wearing a seatbelt, avoiding speeding etc.
To reduce the impact of market risks, we have discussed the importance of setting aside six months of emergency expenses. This can easily be done by calculating the average amount of money you spend each month and saving up the amount in a regular bank account.
Not sure how much you are spending? In that case, it would be a good time to begin tracking your spending. I use a simple excel sheet, which I update at the end of each day with my daily expenses.
At the end of the month, I would total up my spending to see if I am overspending in certain areas such as a transport, food or leisure.
By doing up an excel sheet of your spending, it would simultaneously enable you to realize how much you are truly spending each month.
With regards to concentration risk, another aspect is to consider the quality of the assets held under the fund. Just as important as diversification is the assets being used to diversify the holdings.
For instance, if you had to pick between two ETFs that focuses on Technology stocks, it would be less risky to invest in an ETF that holds Established US Technology stocks such as Apple and Facebook, vs an ETF that holds technology stocks from developing nations such as China and India.
At the end of the day, it is important to do your due dilligence and planning before beginning to invest in ETFs.
Disclaimer: All investment opinions made in this article are based on personal experiences and are meant for informational purposes only. As such, information from this article shall not be taken as investment advice, nor is not a substitute for financial advice provided by a professional. While we strive to provide accurate and up to date information, by engaging in investments, it will be at your own risk.
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