6 mistakes to avoid when investing in ETFs

October 22, 2014 08:48 PM

Making the right decision when it comes to choosing retirement investments can make the difference between having plenty of money for your golden years or struggling to get by. At some point, you may hear of exchange-traded funds, or ETFs.  They're a great addition to virtually any retirement portfolio, but only if you avoid some of the more common mistakes.

Here are six you should be sure to avoid.

1. Not researching the fees

The fees or expense ratios of most ETFs are less than other traditional investments, but that doesn't mean there aren't variances within that space. There are indexed ETFs and actively managed ones, and the former typically have lower fees than the latter.

If you think expense ratios don't matter, consider this example: You have an ETF that you originally invest $5,000 in and add $1,000 each year (with an average return of 6% annually). If the fund had an expense ratio of 0.25%, you'd pay $5,357 in fees over the course of 30 years. But if the expense ratio had been 0.75%, that figure would jump to $15,205--a difference of almost $10K.


2. Replacing all stocks with ETFs

Because they're such a popular and attractive investment option, you might be tempted to avoid stocks altogether. This is a mistake. There are plenty of examples when investing directly in a stock will lead to better performance than simply choosing an ETF that holds it. Taking advantage of the recent spike in Apple's stock price is a great example. You would have enjoyed better returns by investing directly because you factor out the other possibly less well-performing investments in the ETF. You can make ETFs a higher priority, but don't quit stock market investing.

3. Selling too soon

Although this applies to almost all investments, it bears repeating: There are going to be downturns in the market (even though you might not believe that, considering the recent performance of Wall Street). However, getting out too soon can be detrimental to your portfolio. Your retirement nest egg is a long-term investment and should be treated as such. Ignore short-term market downturns (unless you're on the cusp of retirement), and ride out the storms.



4. Not tracking long-term performance

When you're investigating the performance of any particular ETF, you should automatically throw out the short-term data. There are two reasons for this: First, in the current financial climate, the majority of ETFs (and virtually any other investment) are all up, as the market has been performing quite well for a few years. On the other hand, back in 2008-2009, any investment you might have researched would have a terrible short-term record. Therefore, use the benchmarks starting at the five-year timeframe and make your decisions based on that.

5. Mistakenly investing in something that's not an ETF

Make sure you're actually investing in an ETF. Just because it looks like one from its stock ticker or title, doesn't necessarily make it one. There are some investments called exchange-traded notes, and there are also closed-end funds that might look like ETFs, but actually aren't. Make sure you do your homework on the investment's structure, its tax consequences, prior history, and the actual holdings to make sure it truly is an exchange-traded fund.

6. Failing to achieve true diversification

ETFs are basically diversified investments, but don't be swayed into believing that investing in just one of them will automatically allow you to have true diversification. Some are diversified, but in only one asset class asset class--they're focused solely on the energy or precious metals space, for example. Make sure that the totality of your ETF investments has a broad base of investments in commodities, stocks, bonds, and possibly international funds. That's the best way to ensure true diversification.

As with just about anything when it comes to your money, research and homework are the two main keys. Use ETFs to your advantage, and be make sure you avoid the above mistakes. When you're lying comfortably on a beach in Ft. Lauderdale once you've called it a career, you'll be glad you did.


What other mistakes should be avoided when investing in ETFs? Let us know if you have any other tips--leave a comment below.

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About the Author

Michael Thoms is an active investor who writes about investing strategies, money management and retirement options. He may be reached at andrew@moneycrashers.com.