Seven Essential Tips for Successful ETF Investing

Published on by on July 27, 2009 | Updated April 11, 2011

Over the past several years, the popularity of ETFs has surged as investors have poured billions of dollars into these funds. The fact that ETFs attracted $260 billion in inflows in 2008 despite a the financial crisis is a testament the numerous advantages they hold relative to mutual funds and individual securities. If you’ve decided to adopt a passive, “buy and hold” approach to investing, ETFs may be an optimal way to develop an efficient, well-diversified, low-cost portfolio. And for more active investors, ETFs can be ideal for quickly gaining exposure to broad sectors, asset classes, and industries. For any investor considering the use of ETFs in their portfolio, here are seven tips to maximize your return.

1.  Establish Your Investment Goals and Risk Tolerance

The first tip on our list sounds obvious and easy, but establishing investment goals and risk tolerance is the most critical aspect of implementing a successful investment strategy. In connection with establishing your investment goals, determining your ability and willingness to take risk will allow you to develop an ETF portfolio that will minimize risk given the required level of return.

Establish Your Investment Goals and Risk ToleranceLet’s clarify what we mean when we say “establish your investment goals.” Obviously, we would all love to generate 100% annual returns every year. Instead of focusing on your desired return (we’ll get to that next), start with your required return. Your required return generally consists of two components: capital appreciation and current income. Young investors will likely focus on capital appreciation (e.g., “I need to have total assets of $5 million by the time I retire in 2050″), while current income may be more important to older investors and retirees (e.g., “I need my portfolio to generate cash of $100,000 per year to cover living expenses”).

The second part of your investment strategy involves your constraints, the most significant being your ability and willingness to take risk. Although risk capacity depends on individual investor characteristics, there are some general rules of thumb.

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