When you have little more than a basic understanding and minimal experience, one option for investing in the stock market is to use passive management funds, which are typically characterized by higher diversification, lower risk and reduced commissions. Even the most inexperienced investors should’ve read that opening sentence and thought, “This must be about ETFs.”
Correct! Exchange-traded funds (ETFs) allow you to invest in a diversified range of assets, such as equities and bonds. They are extremely liquid and traded on the stock exchange, and you can buy and sell them whenever the market is open.
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However, just because ETFs are a flexible and reliable investment option — and a wildly popular one at that — that doesn’t mean you should simply invest in them haphazardly. While it’s true that ETFs are “safer” than many other financial opportunities, they have their unique risks, and investors can make mistakes when buying them.
The No. 1 ETF Mistake
Chasing trendy assets, not managing risk efficiently and expecting the funds to outperform are common mistakes Americans make when buying ETFs. However, according to Vince Stanzione, CEO and founder of First Information, there is one big mistake budding backers make when purchasing these pools of stocks or bonds.
“A mistake many make when buying an ETF is not checking what is inside the ETF and most importantly the weighting of each stock, which change daily,” Stanzione said.
Examining the ETF is crucial before investing. “Remember, an ETF is a basket of stocks that normally tracks an [underlying] index — for example $SPY tracks the S&P 500,” said the veteran trader, self-made multimillionaire and author of “The Millionaire Dropout.” “What can happen is an investor thinks they have a good spread of stocks and exposure but in reality, they are fairly crowed into a few stocks, which is fine when it’s going your way but not so great when it goes against you.”
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Not All ETFs Are the Same
Understanding an ETF’s objective and the kinds of assets it offers is essential. As Stanzione mentioned, many popular funds track the S&P 500, but others are industry- or sector-specific, which could prove to be substantially more volatile than one that has a balance of tech, energy, retail, health, utilities and communications holdings, for example.
With big market cap technology companies dominating the stock market, particularly the S&P 500, many ETFs continue to prioritize tech stocks that move the index (especially the Magnificent 7 stocks), and, subsequently, the ETF’s performance. Stanzione gave an example: “If you hold the SPY and QQQ (NASDAQ-100 index) you have a big exposure to NVIDIA stock,” he said.
Not too many investors are going to argue having the best-performing stock of the last 20 years heavily weighted in their ETF, but there might be companies you want to steer clear of or industries on which you want to center your attention. In the case of investing in a global ETF, you’d need to consider a region’s economic and geopolitical climate and how certain factors could influence your ETF’s performance.
Depending on the ETF you choose, you should know what the fund is tracking and understand the underlying risks associated with it. Despite offering low volatility, not all ETFs are the same.
“Various websites will give you the weightings of an ETF,” Stanzione told GOBankingRates, before recommending a comprehensive site like Finviz.com, which provides financial visualizations of stock details and holdings breakdowns.
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This article originally appeared on GOBankingRates.com: I’m a Financial Expert: This Is the No. 1 Mistake Americans Make When Buying ETFs
