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ETFs for Beginners

Are you just starting with exchange-traded funds (ETFs)? If so, you may have little or no direct participation in the financial markets. Maybe you’re transitioning from a full-service brokerage or employer-sponsored retirement plan to an online service like Ally Invest. Your investing objectives may run the spectrum from conservative to aggressive, but it’s likely you don’t grasp the full meaning and implications of these viewpoints.

Like most new traders, you have high expectations for your investments, and you’re eager to expand your general market knowledge and investment experience. You may have heard about asset allocation and retirement planning, but don't really understand how those processes work.

On the trading side of things, you might be lured into trading an ETF because the sector it tracks is in favor or is experiencing increased volatility. However, you may not realize the higher the volatility, the higher the skill set needed to manage such positions. It’s crucial to understand the concept of liquidity and how its importance increases as a trader’s holding period decreases.

Keep a cool head

Don’t allow emotion to take over once a trade or investment has begun. This may lead to you holding onto ETFs with losses even as the reasons for the original investment have deteriorated. You may hope that a losing ETF will recover, so you can get back to even. There are other errors to avoid, such as pulling the sell trigger too soon and selling your ETF at break-even or with only small profits.

As a new ETF trader, you realize ETFs represent a basket of investments, but you likely don’t know what assets are held by the fund manager nor realize not knowing these details can wreak havoc on your investment. Rookies may erroneously think fees for ETFs are always lower than those of mutual funds and don’t know to look closely at commissions and expense ratios. It can be daunting to compare mutual funds and ETFs in a comprehensive manner to determine which type of investment is better suited in certain conditions.

You may not be aware that ETFs can go up and down in value or that your shares can become worth more or less than their original cost. The unique risks of specialized or non-traditional ETFs aren’t always apparent, either. It’s tempting to be attracted to an ETF for its successful track record, but a bit more challenging to interpret those figures and recognize that past performance is not an indication of the future.

As a new ETF investor, aim for mastering these fundamentals:

  • The basics of ETFs, their fees and expenses, and how ETFs can impact your taxes
  • How to obtain a prospectus, either by mail or online, and understand it
  • The meaning of an ETF’s stated average annual returns
  • How to obtain and read basic quotes using a ticker symbol (bid, ask, size, last, change, high, low, open, close and volume)
  • The concept of dollar cost averaging, its risks and costs, and if it’s right for you
  • How T+3 settlement affects ETF transactions
  • Order entry terminology (action of buy or sell, quantity, price, type of order, duration)
  • Position terminology (long, short)
  • Monitoring the major market indices (S&P 500, DJIA, Nasdaq composite, Nasdaq 100, Russell 2000, etc.)
  • The difference between an ETF and an index
  • How to regard your gains or losses as real, even if they are still unrealized
  • What basic SIPC insurance is (and why it matters)

Improve your trading skills by:

  • Reviewing the basics of investing in stocks and bonds
  • Using limit orders for nearly all trades
  • Understanding if and how dividends are distributed for a particular ETF
  • Understanding how commissions and fees impact your bottom line
  • Anticipating and planning for all possible outcomes for your trades, not just the positive scenarios