When purchasing an Exchange Traded Fund (ETF), mutual fund, or individual stock to invest in do not make the classic mistake of chasing returns. In this post, we will examine ETFs and to a degree mutual funds as they act similarly. So, what is that mistake? It is people who look at and select an EFT by examining its past performance. And let us be honest here, that is not the way to select any investment. The reason you should not invest based on past performance is that it is due to the fact they do not predict or indicate what may happen in the future. And with over 1,700 ETFs in the United States alone, let us examine how you may want to go about selecting the right ETF for you.
Passive in Nature
As I alluded to earlier, ETFs and mutual funds are similar in how they act and can be used. The main difference between an ETF and a mutual fund are many mutual funds are actively managed by a collection of highly paid asset managers to select the investments for the fund. And ETF by its design is passively managed meaning it follows an index or a set of investment criteria that bounds the manager to invest in the designated investments simply. As an ETF is passive in nature their returns are dictated by the index they track or the investments that are laid out in the prospectus. Actively managed funds by their nature cost more due to the salaries of the managers and fees associated with active trading, not to mention the tax trading incurs. ETFs by their nature, have minimal trading fees or taxable events as they only buy and sell when the index they track changes or investment is deleted or added from the core strategy.
Keep Costs Low
By selecting an ETF over a mutual fund, chances are on your side that the fees will be considerably lower. But that does not mean that you can ignore the fees as even a small increase in ETFs fees can mean the difference of tens of thousands of dollars in a retirement account over the course of decades. In the world of ETFs, a fund that tracks an established index such as the S&P 500 will have the lowest fees as there literally nothing for the fund’s managers to do other than track the index. And as such, the taxable events of ETFs are considerably lower than that of a mutual fund that is managed. And like fees, taxes can mean thousands of dollars being taken from your account when that money could work for your benefit.
Avoid Trends
Most people who purchase an ETF or mutual fund as their investments do so based on something. What is that something? For many of us, it is the wrong assumption that an ETF that has a history of good returns will continue doing so. Yes, history is part of the equation but not a real deciding factor for a true investor. The time to buy any investment is when there is a margin or error that will tilt the odds of success in your favor. But buying low is not always a possibility so what is the solution? Well, it comes in the form of dollar-cost averaging or in plain terms, setting up a schedule to buy a set dollar amount on a set timetable. We do this with our workplace retirement accounts such as a 401(k) where they take a set amount and invest it for you on a schedule. This way you buy more when the price is down and less when it is up. But on average, you will get a lower price per share and more shares in your account when compared to buying when the mood strikes you.
Diversify
And the final key to investing success is to diversify your investments. This means on basic terms to have an allocation of money in stocks, bonds, cash, or some other asset class that you have done your research on. When stocks go up, bonds go down as a rule. And the cash allows you to buy if an investment presents itself at any opportunity. But just buying a group of ETFs does not mean you will achieve true diversification. If all the ETFs you buy are invested in stocks, you may be well-diversified when it comes to stocks but that is just a single asset class. But never fear, there are ETFs for numerous different asset classes from individual stock classifications such as a small cap or large-cap to ones that invest in bonds or real estate. Do your research on what an ETF owns before you purchase them to ensure you achieve true diversification.
If you follow these tips, you will be well on your way to investing success and a long-term investing plan. If you are not sure of any aspect of an investment, seek out the assistance of a fee-only Registered Financial Consultant.
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