Investing in ETFs has become quite popular, particularly because they offer a mix of diversification and liquidity at a relatively lower cost compared to mutual funds. Despite their advantages, investors often make common mistakes which can be quite costly. Take the case of timing the market, for instance. I've seen so many people try to outsmart the market by buying ETFs at what they think is a low point, only to find the price drop even further. According to recent studies, holding investments for the long term yields an average return of around 7-8% per year, which helps cushion against market volatility. But trying to time the market rarely goes according to plan.
Another mistake that often happens is not paying enough attention to expense ratios. While most ETFs have lower fees compared to mutual funds, there can still be a significant difference between different ETFs. For example, an ETF with a 0.04% expense ratio versus one with a 0.50% expense ratio can result in a substantially different return over a 20-year period when you're investing substantial sums. Paying an extra 0.50% per year on a $100,000 investment means an additional cost of $500 per year, which compounds over time.
Chasing performance is another pitfall. Just because an ETF performed well last year doesn't mean it will do so this year. Historical data from companies like Vanguard shows that top-performing funds often don't maintain their status. One of my friends jumped into a tech-focused ETF after seeing its stellar 40% return in a single year, only to face a 20% loss the next. It's a classic case of recency bias, where recent performance overly influences decision making.
Underestimating the impact of taxes can also lead to unanticipated costs. ETF dividends are taxable, and capital gains tax may apply when you sell your ETF. If you're in the 22% tax bracket and your ETF generated $1,000 in dividends, you'd owe $220 in taxes. Using tax-advantaged accounts like IRAs or 401(k)s when possible can help mitigate this issue.
Failing to diversify properly within ETFs is also a significant risk. I know it's tempting to load up on sector-specific ETFs after a sector shows impressive gains, but this can lead to a lack of diversification. For instance, investing heavily in technology ETFs can be risky if the tech sector underperforms. In 2000, the tech bubble burst, and those heavily invested in tech ETFs saw substantial losses. Spread your investments across multiple sectors and asset classes to mitigate risk.
Liquidity is another factor that many overlook. Some ETFs are thinly traded, meaning there are fewer buyers and sellers. This can result in larger spreads between the bid and ask price, leading to higher trading costs. Checking the average trading volume of an ETF before purchasing is a good practice. An ETF with a daily volume of 100,000 shares is generally considered more liquid than one with a daily volume of 10,000 shares.
Consider the underlying assets and their geographical locations. Investing in ETFs that focus on emerging markets can provide high returns but also comes with high volatility and risk. In 2008, the financial crisis hit emerging markets hard, leading to substantial losses for those holding emerging market ETFs.
Ignoring the importance of rebalancing is another common mistake. Over time, some ETFs in your portfolio will grow faster than others, leading to an imbalanced portfolio. Rebalancing annually can help maintain your desired asset allocation and risk level. For example, if your target is a 60% equity and 40% bond portfolio, but equities perform exceptionally well, you might end up with 70% equities and 30% bonds. Rebalancing back to 60/40 can help manage risk.
Understanding tracking error is important. This term refers to how closely an ETF follows its underlying index. A large tracking error means the ETF isn't performing in line with the index it's supposed to mimic. Imagine buying an S&P 500 ETF but finding it consistently underperforms the S&P 500 by 1%. That's a significant tracking error and erodes your potential returns over time.
Avoiding complex or leveraged ETFs unless you fully understand them is crucial. Leveraged ETFs aim to amplify the daily return of an underlying index, often by two or three times. While this sounds appealing, it's important to note that these ETFs reset daily, making them unsuitable for long-term investments due to the compounding of daily returns. A 2x S&P 500 ETF might sound great, but if the market fluctuates, it can lead to significant losses more quickly than expected.
Lastly, investing without a plan is a frequent issue. A well-thought-out financial strategy is essential for investment success. Without clear objectives, such as retirement planning, buying a home, or a child's education, it's challenging to make informed investment decisions. Your plan should include your risk tolerance, time horizon, and investment goals. I remember talking to a colleague who invested heavily in ETFs without a clear plan and had to sell investments at a loss to cover an unexpected expense, something that could have been avoided with proper planning.
If you're new to ETF investing and looking for a place to start, you might want to check ETFs for Beginners. Gaining a solid understanding of how ETFs work and the common pitfalls can go a long way in ensuring a successful investment journey.