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These Are The Four Biggest Misconceptions About Investing In ETFs, Says Behavioral Finance Pro

It’s not easy to keep your emotions out of investing.

Those that follow Wall Street’s daily moves may often hear stock market commentators use terms like “weak hands” and “shaken out” to refer to investors who can’t bear the pain of sell-offs or times of higher-than-usual volatility.

Those buyers aren’t exactly few in number. The group, made up largely of individuals, has the power to meaningfully exacerbate moments of weakness, making broad-market declines worse than feared or multiplying the effects of certain stocks’ swings.

But there are a few simple rules investors can follow to avoid getting caught in anxiety-fueled drops or becoming the weak-handed sellers themselves, says Dan Egan, Betterment’s managing director of behavioral finance and investing.

Here are the four main tips he shared with CNBC’s “ETF Edge” on Monday about managing your instincts and using behavioral investing to your advantage.

One of Egan’s biggest tips for investors is to watch out for themes. The rise of internet culture has sped up the widespread adoption of fads like cannabis investing, making it difficult for people to fully vet thematic trends before deciding to buy in, he said.

“If your brother-in-law is talking to you about it over Thanksgiving, you might want to watch out for it,” Egan said in the Monday interview. “The ability to go to market with a new ETF based upon a theme has dropped. The asset base that you need in order to launch that fund has gone down, too. So, we’re seeing quicker uptake on whatever the latest fad is.”

To determine if something is a viral trend, Egan asks himself a few questions: “How quickly did the underlying asset price come up? How much are people talking about it on social media? ... How fast is this going to spread?”

The most important question, though, is “has it performed well recently?” Egan said. “If no and it’s still growing, that’s interesting. If yes, then it’s more likely to be speculative.”

Egan’s second investing rule? You don’t need 50 ETFs.

“One of the things I like about New Year’s is it gives you that fresh start where you can say, ‘Maybe it’s time for me to do a little bit of house-cleaning,’” he said. “I’ve done this: you accumulate holdings over the years. Here was this thing that was the best choice maybe 10 years ago, and ... the big names, over time, sometimes aren’t the best bet for you.”

One of the most common reasons investors are reluctant to sell out of their long-term positions has to do with taxation, Egan said.

“One very common bias, especially in taxable accounts, is that people don’t want to realize the taxable gains and pay the tax,” he said. “In a weird way, they’ll end up paying more over the life of a fund if it’s charging an extra 20, 30 or 40 [basis point]s than if they just sold out of it and went to something cheaper.”

In short, “pulling the Band-Aid off” and cutting your portfolio down to a manageable number of holdings can actually improve performance, Egan said.

Despite the monster gains funds like the S&P-tracking SPDR S&P 500 ETF Trust (SPY) have accrued over the years, Egan has also found that the biggest aren’t necessarily the best.

“You can get the exact same exposure as SPY for one-third of the cost with VOO,” the Vanguard S&P 500 ETF, Egan said.

“There’s a lot of big names — EFA [iShares’ Europe-focused fund], EEM [iShares’ emerging-markets fund] — that are funds that have been around. They’re very liquid. They’re very large,” he said. “They’re usually used by large institutional investors because of that liquidity. They can count on it in order to trade it. But that doesn’t mean it’s necessarily good for a long-term, buy-and-hold investor.”

That point is especially important when it comes to teaching kids about investing, the behavioral expert said. Often times, parents purchase the largest, most successful and most liquid funds for their kids, but Egan prefers to let the younger generations make their own mistakes.

“There’s the School of Hard Knocks [and] there’s the School of Hard Stocks,” he joked. “You’ve got to throw them in there with a little bit of a guardrail on. You’ve got to give them the money; you’ve got to let them make the mistakes.”

In other words, “the best way to learn is to actually take your hits,” he said. “You’ve got to learn that you’re not the best investor ever and the best thing for you to do is dedicate your time somewhere else. So, give them money. Let them invest. Let them learn their own way.”

Egan’s fourth rule is to be careful when you trade, particularly in the first and last half-hours of the trading day. Around each day’s open and close, the spreads, or the differences between stocks’ bidding and asking prices, tend to be at their widest.

Professional traders may try to take advantage of the bigger spreads, but Egan advised individual investors to wait until the dust settles.

“There’s a lot more noise and uncertainty then, especially if you’re trading in overseas assets,” he said, adding that investors should “set limit orders if you’re trading ETFs.” A limit order is a request investors can place to buy or sell an asset at a specific price.

One of the behavioral pro’s unofficial rules for investors is to keep their eyes on the horizon when it comes to their retirement savings, which Betterment does by providing its clients automated updates about their financial health.

“We’ve got, like, a 40-year time horizon that we’re working for here. What you need to know is I am doing the right things today, I’m taking the right steps, doing the right actions in order to put myself on a good path,” he said. “I’m not going to come in and be able to bench-press 250 pounds today, but if I come in and I do my reps, I’ll get there eventually.”

Still, not enough people start taking retirement seriously when they need to, Egan said, because the system of saving combines “the three things that people dislike most”: a long investment horizon with little to no feedback on progress; an inability to compare your portfolio’s performance with that of your peers; and a reduction in spending.

“That’s like a perfect recipe for people not wanting to do that thing,” Egan said. “Especially when people are young and they have a lot of time, there’s other goals they want to knock over quicker, like ‘I want to get married, I want to buy my first house, I want to feel like I’m sort of wealthy compared to my peers.’ So, all these things set us up to say, ‘Well, I’m going to start saving for retirement once I hit 45 or 50, when I have the spare cash and when this is really looming.’ And, unfortunately, that’s when you have less time to grow.”

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