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This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Not so long ago, investors only had a couple of viable choices for their investing dollars. Now, though, you can modernize your portfolio very simply, thanks to the boom in a relatively recent financial innovation: exchange-traded funds.
Stocks vs. funds
Before the ETF came around, you had a threshold decision to make before you could implement a smart investing plan. If you were comfortable picking individual companies that you thought would beat the overall market, then you could buy shares of those stocks directly. Although commissions on individual stocks used to be exorbitantly high, the rise of discount brokerage firms made it far easier to buy shares affordably.
On the other hand, if you didn't want to buy individual stocks -- or you didn't have the tens or even hundreds of thousands of dollars that you'd need to build a diversified portfolio of stocks -- then you would typically go with mutual funds. With actively managed funds, you turned over the decision-making process to your fund managers, who'd buy and sell stocks at their discretion. The benefit, though, is that you got to invest in a diversified portfolio of stocks with a relatively small investment. The downside of funds, though, was that you could only trade them once every day -- and as investors discovered during the 1987 stock market crash, having to wait until the end of trading to get out of a plunging market could cost you a huge chunk of your net worth.
And then there were three
ETFs have given investors the best of both worlds. On one hand, you can buy and sell shares of ETFs whenever the market's open, just as if they were individual stocks. But unlike stocks, ETFs give you the same benefits of diversification that mutual funds offer. And best of all, with so many ETFs using passive indexing strategies rather than active management, they tend to be cheaper than their mutual fund counterparts -- in some cases, significantly so.
But with about 1,350 ETFs in existence today -- and hundreds more in line to become available to investors soon -- trying to pick the right ones can leave you hamstrung. To make your decision making easier, here are a few rules for picking the best ETF for your own portfolio.
1. Know your strategy
The most important element of finding the right ETF is to have a firm grip on how you want to invest. By having a strategy in mind, you can avoid ending up with exactly the wrong sort of fund.
For instance, long-term investors should avoid leveraged ETFs like ProShares UltraShort Silver (NYSE: ZSL ) and Direxion Daily Financial Bull 3X (NYSE: FAS ) . The reason isn't that those funds are inherently bad -- although some critics might find themselves tempted to say so. But because they're designed for traders who think of holding periods in days rather than years, leveraged ETFs are completely contrary to a long-term mindset.
Similarly, certain investing themes don't match up well for every investor. For instance, many investors looking for current income have flocked to dividend ETFs Vanguard Dividend Appreciation (NYSE: VIG ) and Vanguard High-Dividend Yield (NYSE: VYM ) . But if you don't need or want taxable income now and instead prefer companies that invest all their spare cash into hyper-fast growth, then those ETFs won't meet your needs.
2. Focus on cost
One of the biggest benefits of ETFs is that you know exactly what you're investing in. Each day, ETFs tell you what stocks they own, and many index ETFs track easy-to-understand measures that you can follow on your own.
As a result, there's no reason to pay any more than you have to for ETFs. Looking for low expense ratios makes sense for long-term plays, so broad-market ETFs Focus Morningstar US Market (NYSE: FMU ) and Vanguard S&P 500 ETF (NYSE: VOO ) can save you over more specialized funds that tend to have higher expense ratios. Other costs, such as commissions, play a bigger role for more frequent traders.
3. Just because you can trade doesn't mean you have to
ETFs let investors easily transform themselves into traders. The rise (and recent short-term fall) of the heavily traded SPDR Gold Trust (NYSE: SPY ) shows in part how ETFs have become trading vehicles.
But you can be a contrarian and use ETFs not for trading but for investing. Just be sure to stay away from ETFs that don't work well as long-term investments -- and don't succumb to the pressure of clicking the buy and sell buttons that ETFs offer.
Give ETFs a try
If you haven't tried out ETFs in your portfolio, it's time to give them another try. For many investors, ETFs can make it easier to create the perfect mix of investments for any set of goals.
To learn more about these financial innovations, be sure to read the Fool's free special report on ETFs. You'll find the names of some great funds along with more information to get you started.
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.