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Over the last few years, more and more employer retirement plans have been adding exchange-traded funds (ETFs) to their investment options. That means most of us have, or will have, the choice of selecting mutual funds, ETFs, or a combination to invest for retirement through our 401(k)s.
Before you start investing in ETFs—whether in your 401(k) or in another retirement account—read this breakdown of ETFs vs. mutual funds. You should never invest in anything you don’t understand.
What Is a Mutual Fund?
When an investor (like you and me) buys a mutual fund, they contribute to a pool of money to be managed by a team of investment professionals. That team selects the mix of stocks, bonds, money market accounts, and other options in the mutual fund. My personal investing approach includes spreading my retirement investments equally among four types of mutual funds:
- Growth and Income
- Aggressive Growth
This approach helps you avoid the risks that come with investing in single stocks while using the power of the stock market to grow your retirement fund.
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When you’re choosing mutual funds, make sure to look for and invest in funds that have good track records.
What Is an ETF (Exchange-Traded Fund)?
Like mutual funds, ETFs invest in a variety of companies. ETFs generally mirror a market index, like the Dow Jones Industrial Average, by investing in most or all of the companies included on that index. This type of passive management keeps ETF fees low since there’s no team of managers selecting companies—the fund just follows the market index.
ETFs are also designed to be bought and sold on the stock market exchanges during the trading day, so ETF investors can buy or sell in response to daily stock market swings. Mutual fund transactions, on the other hand, are completed after the markets close.
3 Things to Consider Before You Invest in an ETF
There are lots of ways you can invest your money—from a simple savings account to the most complicated investment. But, like a simple savings account, most of those more complex investing options aren’t a good fit when it comes to saving for retirement.
Since ETFs and mutual funds seem similar, it’s easy to think either, or both, would work well in your retirement plan. But I recommend mutual funds over ETFs for retirement investing. Here’s why:
1. Mutual Funds Are Made for Long-Term Investing.
To build wealth for retirement, you need to select your investments for the long term. Mutual funds are a great way to do this. Once you choose your funds, you want to leave them alone for 10, 15, 20, or more years—as long as they continue to perform well.
On the other hand, ETFs are traded like stocks (during the day, not after the markets close). That means investors can try to time the market, buying and selling ETFs for short-term gains and quick cash. And that’s not a good idea.
"To build wealth, you need to think marathon not sprint." — Chris Hogan
A Fidelity study showed the impact of selling when the market gets rocky versus staying invested for the long haul. On average, those who sold their stocks during the 2008 market turmoil and then reinvested that money gained 6.1%. But those who fought the panic and stayed put gained an average of 21.8%.(1)
2. ETFs Are Not Fee-Free.
ETFs can be paid for in multiple ways: They can have operating costs—sometimes with transaction costs on top of that—or they can be in a fee-based account. Since most retirement investing is done through monthly contributions, those operating and transaction fees can quickly eat into your returns if you’re charged every month you add to your investment.
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While ETFs usually carry lower fees than many mutual funds, you lose the personal touch that comes with working with a professional.
"When you invest in mutual funds through an experienced financial advisor, you get one-on-one help to make the most of your money." — Chris Hogan
That’s not the case if you’re trading ETFs in an account.
3. You Can Do Better.
Using an ETF to mimic a market index (like NASDAQ or the Dow Jones Industrial Average) sounds like a great idea. Over the long term—30 years or more—the S&P 500 Index averages 10–12% growth.(2) So, it’s a good plan, right? In reality, there are better options.
If you like the idea of passive investing—leaving an investment alone for a long time—then an index mutual fund (a fund made up of stocks within a particular market index) will allow you to "invest in" an index (or the companies within an index) without paying the common brokerage fees of an ETF. And you avoid the temptation to day trade or jump out of the market when it dips.
Even better than an index mutual fund, a growth stock mutual fund can actually beat the stock market’s average. That’s the job of investing experts who manage a mutual funds’ investments. And they know what they’re doing.
It may seem like I know a lot when it comes to investing, but even I prefer to work with a financial advisor to help me with my investing decisions. And you should too. You can find a knowledgeable financial advisor through the SmartVestor program’s nationwide network of investing professionals. Contact a SmartVestor Pro today!
About Chris Hogan
Chris Hogan is the #1 national best-selling author of Retire Inspired: It’s Not an Age; It’s a Financial Number and host of the Retire Inspired Podcast. A popular and dynamic speaker on the topics of personal finance, retirement and leadership, Hogan helps people across the country develop successful strategies to manage their money in both their personal lives and businesses. You can follow Hogan on Twitter and Instagram at @ChrisHogan360 and online at chrishogan360.com or facebook.com/chrishogan360.