It’s 2012, you’re sitting down at the Thanksgiving dinner table and turn to your left only to hear your uncle yell across the table “I only invest in ETFs Frank. Nothing else!”. It probably meant nothing to you back then but after starting your first job and now in need of somewhere to invest your savings, you start to wonder ”what actually is an ETF”...

In this post we break down what an ETF is (with examples) so you don’t have to deal with a lecture from your uncle.

In our last post, we talked about stocks tracking the performance of a single company. ETFs on the other hand are investments that track the performance of a collection of companies (or bonds, etc but we focus on stocks). You can think of it as investing in a single player (stock) versus an entire team (ETF).

ETFs are traded on the stock exchange just like stocks are however the way their price is computed is a lot more complicated. For simplicity, we won’t dive into that and you can read more about it here. All you need to worry about is “will the value of all the companies tracked by the ETF go up or down”? Since ETFs usually track a collection of stocks in a specific sector like technology, you are basically predicting “will the tech industry do well long term”.

It’s also a lot easier to bet on industries and sectors like healthcare and tech over individual companies. For example, no one knows which company is going to dominate the space industry but if you invest in an ETF that tracks all of them, you’re betting at least one of the will be huge.

Why would someone choose to invest in an ETF over a stock? Stocks like Apple (AAPL) have higher returns than most ETFs so won’t they make me more money? Let’s look at an example.

Example: Let’s pretend there’s an ETF that tracks Apple ($100), Microsoft ($200), & Google ($500). John is invested in a single share of Apple ($100) while Emily is invested in two shares of the ETF at $50 each.

Pro ETF: One day, a new startup Orange comes out with an incredible phone and laptop. Everyone decides they want that instead over Apple’s causing their revenue to tank and the share price to drop from $100 to $50. John has now lost $100 ($50 * 2) in a single day since he was entirely invested in Apple. Emily on the other hand might just be down to $80 ($20 loss) since the ETF she’s invested in tracks more than just Apple and dropped from $50 to $40.

Con ETF: On the other hand, one day Steve Jobs comes out of hiding and says he has a ton of new features for Apple. Everyone is extremely excited (bullish) and the value of Apple rises to $150. John just made $100 ($50 * 2) in a single day while Emily might have just made $20 (ETF going from $50 to $60).

As you can tell, investing in an ETF is generally much safer but gives you less extreme returns. You’ve hedged yourself against the performance of a single stock going down by owning something that tracks multiple.