Investors who purchase individual stocks run the risk of losing a significant proportion of their investment through just one poor decision by management.

Qantas (ASX: QAN) investors had their holdings cut by 10% in just one day when management downgraded its earnings forecast last week, while Forge Group (ASX: FGE) investors lost over 80% when cost overruns were reported at two important projects in late November. Such declines can be devastating for smaller portfolios. Alternatively, an investor could use an Exchange Traded Fund (ETF) to diversify holdings and limit the downside of share price declines such as those above.

Similarly, you may be interested in investing in macro (i.e., large scale) trends but not want the risk in investing in a single stock, or may not have enough cash to diversify among stocks exposed to the trend. An example of this would be investors who are bullish on iron ore, but have only a few thousand dollars to invest. Instead of investing, say, $1,000 in each of Fortescue (ASX: FMG), Rio Tinto (ASX: RIO) and BHP (ASX: BHP), the investor could purchase an Exchange Traded Fund (ETF) that tracks an index of listed mining companies.

What exactly is an ETF? Wikipedia defines an ETF quite well:

“An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index”

The benefits of ETFs are many and varied, however, the main points to consider are that they are a low-fee, transparent, and simple way of investing in a huge range of stocks, commodities and currencies.

Our iron ore investor could put the $3,000 into the Betashares ASX 200 Resources ETF (ASX: QRE) as a way of limiting risk while gaining exposure to strong iron ore prices. The holdings in the ETF can be found here.

ETFs allow investors to easily diversify their portfolio among 5, 10, or 200 stocks as they please. Australian investors can also invest in US, European or Asian shares and bonds through ETFs.

Foolish takeaway

Investors just starting out or looking to take advantage of global or sector-specific themes should consider ETFs as a way of providing instant diversification. While investors will be partially protected from sharp falls in the share prices of individual companies, they will also miss out on sharp rises.

Looking for dividends?

Most ETFs pay dividends and franking credits quarterly to investors. The ETF operators take their fees from the dividends of companies held in the index and pay the remainder to ETF holders. For example, the Vanguard ASX High-Dividend Yield Index (ASX: VHY) paid a 4.5% dividend over the past year, franked to about 80%.

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Motley Fool contributor Andrew Mudie does not own shares in any of the companies mentioned.