Too Chicken to Trade?

Having trouble committing to a single stock? Nervous about leaping from mutual funds into individual securities?

Bwaaack! Bwaaak, bwak, bwak...

Ignore the taunting, and back away from the high dive. There's an easier way to get into stocks -- ETFs.

Exchange-traded funds (ETFs) are basically mutual funds that, like stocks, trade on a major exchange throughout the day. Like index mutual funds, most ETFs try to match the performance of a particular index, or specific group of securities.

So why not just go with an index fund? Cost, baby, cost. ETF expense ratios tend to be a fraction of those on ordinary mutual funds. Also, the tax hit investors endure because of high trading turnover in mutual funds is greatly diminished in ETFs. So keep your wallet in your pocket when the tax tab comes. In a side-by-side taste test (such as this comparison), you might find more reasons to sample the ETF market.

Fool Tim Beyers says there's an ETF match for almost everyone's taste buds. For example, an Internet-addicted, travel-seeking, not-so-young dad like him might be drawn to Merrill Lynch'sInternet HOLDRs (AMEX: HHH  ) fund, the iShares MSCI Italy Index (AMEX: EWI  ) fund, and perhaps State Street'sConsumer Staples SPDR (AMEX: XLP  ) .

Need a shot of fixed-income stability in your portfolio but are bored with bonds? Check out the Dow Jones Select Dividend (NYSE: DVY  ) -- a basket of dividend-paying stocks. Got a hankering for some small-cap stocks but no idea which one has the most potential? Consider iShares S&P SmallCap 600 (AMEX: IJR  ) . Need a little international flavor in your portfolio? iShares MSCI EAFE Index Fund (AMEX: EFA  ) invests in stocks across Europe, Australia, and the Far East.

Lest we Fools sound breathless about the opportunities in ETFs, allow us to regale you with two sobering details:

1. Because ETFs trade like stocks, you must have a brokerage account to partake. It's easy to open one (about as painful as opening a bank account, actually). Discount brokers are offering all sorts of incentives to get your business. Want 30 free trades, a $100 credit, or five weeks of commission-free trading? Yeah, those got our attention, too.

2. ETFs are best for those who have a chunk of money ready to commit. If you dollar-cost average (add to your investments a little at a time), the trading fees you would pay for multiple transactions would cancel out any cost savings.

Other pitfalls -- such as double coverage or overly expensive ETFs -- are relatively easy to sidestep.

For those considering more sophisticated ETF trading strategies (Options! Shorting! Hedging! Oh my!), Fool writer James Early has a few words of advice. Even mutual fund champion Shannon Zimmerman concedes that there's a place for ETFs in many investors' portfolios.

Are you ready to dip your toe into new waters? Remember, ETFs -- like any investment -- are not an all-or-nothing proposition. Pick a comfortable amount of money to invest, and dip your big toe into new waters and see whether the temperature's to your liking.


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