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Investors must confront thousands of different choices, each competing for their investing dollars. From stocks and bonds to mutual funds and ETFs, you have so many possibilities to choose from that comparing and contrasting different investments can easily become overwhelming.
Even after closer examination, it can be hard to tell many investments apart. Many funds seem to have identical objectives and strategies. Even if you know you want to invest, how can you ensure that you make the best choice every time?
Case 1: The index fund
At first glance, you might think that all index funds are basically the same. After all, index funds are supposed to give you the returns of the indexes they track. What could be simpler?
Yet index funds differ in many ways:
- Index tracked. Nowadays, there seem to be as many indexes as there are funds. Nearly every ETF tracks some sort of index, but many of those indexes are custom-made solely to support a particular ETF concept.
- Weighting. Do you like S&P 500 companies, but don't particularly like the big ones more than the small ones? Then a traditional market-cap-weighted index, which invests hundreds of times more money in big stocks like ExxonMobil (NYSE: XOM ) and Microsoft (Nasdaq: MSFT ) than in smaller stocks such as Advanced Micro Devices (NYSE: AMD ) and Whole Foods Market (Nasdaq: WFMI ) , isn't for you. But you can find other funds and ETFs that invest equal amounts in all 500 stocks.
- Fees. Even when funds are virtually identical, some charge more than others. Vanguard's S&P index fund, for instance, charges 0.15% in annual fees. But some index funds charge much higher expenses and even front-end loads.
So as you can see, picking an index fund takes much more than just tossing a dart at the mutual fund page. You actually have to look through all the fund materials and understand how each fund works to be sure you're getting what you want.
Case 2: Specialty ETFs
The same holds true for more focused investments. Consider, for instance, dividend ETFs. A popular choice is the iShares Dow Jones Select Dividend ETF (DVY). But you'll find plenty of competition from other funds, such as the SPDR S&P Dividend ETF (NYSE: SDY ) .
In many ways, the funds are similar. They both own some of the same names, such as BB&T (NYSE: BBT ) and Kimberly Clark (NYSE: KMB ) . At 0.35%, the SPDR ETF is just a tiny bit cheaper than iShares' 0.40% expense ratio. They both have impressive yields above 5%.
However, the ETFs differ in how they pick the stocks they hold. The iShares fund uses a dividend-weighted index that includes stocks that have increased their dividends or held them stable over the past five years.
The SPDR ETF, on the other hand, has a much tougher hurdle for companies to overcome. Every stock this ETF holds must have raised dividends during each of the past 25 years. That results in a more concentrated portfolio, with around 50 stocks compared to more than 100 for the iShares fund.
How to pick
To make the right choices, you first have to understand what type of choice you're making. In the case of index funds, choosing which index you want to track depends on your own personal investment philosophy -- there's no one right answer, and your best choice may differ from someone else's.
Once you've narrowed down that universe of funds to your chosen index, however, factors such as fees can filter out expensive funds that offer no additional benefit. Using metrics like cost and tax efficiency can reveal the best choice.
With less obvious choices, such as dividend ETFs, picking a fund becomes more subjective. Although past performance can sometimes suggest an advantage to one method over another, there's always the possibility that the future will reverse course. If both funds use sound methods, then either can make a good investment -- even though over time, one will obviously emerge as the better performer.
Don't let too many choices paralyze you as an investor. By focusing on the factors that are most important to you, you can make sure you'll get the right fund for your portfolio.
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