ETFs, which are baskets of stocks, bonds, or commodities that are traded on a stock exchange, are becoming an increasingly popular way to invest especially with young investors. Due to their accessibility, instant diversification, transparency, low expenses, tax efficiency, and ability to be traded like individual stocks, some experts even think they’ll eventually make traditional mutual funds obsolete.
However, there are downsides to be aware of too. If you have ever heard the adage “your greatest strength can be your weakness as well,” then you will see why the following mistakes can creep up on an ETF investor if they are not aware of them.
Mistake: not changing how you invest your money
Many people invest by depositing a set amount into their investment account every month (dollar cost averaging strategy), which they use to buy mutual funds. This can be a mistake with ETFs because you pay a commission for every buy and sell order you place which means that your monthly investment will be reduced by commission costs. (Note: this could be negated if you are with an online brokerage firm that provides free trades.)
Mistake: losing focus of your long term strategy
ETFs are generally viewed as a long term investment holding but because of the benefit of being able to trade it (as often as intra-day), a mistake could be made if the investor gets tempted to buy and sell with more of a short term outlook (read: market timing) which can result in selling at the wrong time and having higher trading costs and taxes.
Mistake: not researching how an ETF diversifies your portfolio
This can work against you in two ways:
- Redundancy. For example, by investing in an ETF that tracks the S&P 500 and also holding a large-cap mutual fund, you are investing in essentially the same type of stock and oftentimes both investments will hold the same companies.
- Liquidity risk of specialized ETFs. The other miscue is if your ETF is invested in a specific sector, for example in an Antarctic oil sands benchmark (I’m inventing a sector), you may have difficulty selling your shares when you want.
Mistake: trading “over your head”
“Just because a strategy exists doesn’t necessarily mean you need to use it.”
One of the advantages of investing in ETFs is the flexibility of how they are traded and the different strategies that can be employed. For example, one strategy is to “short-sell” an ETF. This strategy is used by investors who believe the price of their ETF will go down. The investor in effect borrows shares from the brokerage firm and then will pay back the borrowed shares with the cheaper shares – assuming the price does in fact go down.
Sounds easy right? Nope! This is a practice that only experienced investors might employ and while the reward (a higher return) could be nice, the risk is very high.
Good rule to live by: just because a strategy exists doesn’t necessarily mean you need to use it.
Finally, if you eventually decide to invest in ETFs, in general it’s best when you have a lump sum to invest as that will help minimize trading costs (see mistake 1). Many ETFs will have low minimum investment requirements (could be as low as $250) but be careful, a very low minimum investment may require monthly deposits which, because of commission costs could eat away at your overall return.