Don't Make This Investment Choice Before Reading This First

When I first decided that these super-popular investments might have a place in my portfolio, I spent about six months learning about them and then another six months investing in them to determine how I wanted to use them in my portfolio.

I'm definitely not alone in looking into them. Thousands of Americans have asked themselves the same question I did, and many others are considering their answers right now.

But the reality is that it can be a little overwhelming to decide on your final answer. After all, your decision could mean moving away from an investment that's been the cornerstone of your portfolio -- as well as the portfolios of millions of other Americans -- for years.

So what's this burning question?

Mutual Funds Or Exchange-Traded Funds (ETFs)?
There are many different things to consider, such as tax treatment, costs and legal structure. Looking back at what I have learned, I have decided it comes down to three factors you should consider when deciding which one is right for you.

Let's look at each of these.

1.The Purpose Of Your Investment

First, understand the purpose of your investment. Is it a long-term core holding that you are not going to be trading out of? Is it a market play? Are you looking to just get in and get out? Is it a temporary allocation that you might want to adjust within the next year or two? How you answer these questions is crucial. And if you haven't answered them yet, then you should do so before you move on.

2. How You Plan To Buy The Investment

This one is crucial as well. Are you using a lump sum to get in the market, or are you investing on a regular monthly basis? Additionally. are you going to reinvest any dividends, or do you just want the cash? Reinvesting dividends is a key part of the investment strategy for many investors, including my colleague Amy Calistri, editor of StreetAuthority's Daily Paycheck newsletter. After you know what the purpose is and how you are going to buy, then you can begin to narrow in on a decision. First thing to consider is liquidity issues. If you are investing in a thinly traded area such as an individual country investment, you might not have as much liquidity in an ETF as you would in a mutual fund. Because an ETF is traded like a stock, you will need to have someone on the other side to buy, thus when the market is down, it could be hard to find a buyer. Meanwhile, a mutual fund will typically have the cash on hand to buy your shares.

3. Costs

Costs can destroy your return, so you should evaluate every possibility. When looking at your two investment options, two fees come into play: transaction! fees to ! purchase and management fees. Using the information that you determined on your purpose and how you are going to buy, come up with an estimated cost per each type of transaction. For example: An ETF will have a transaction fee to buy the shares plus a management fee. This might look like $7.95 per trade plus 0.06% per year and a sales transaction fee of another $7.95. Meanwhile, your mutual fund might have no transaction fee and a management fee of 1.25%. Don't forget fees for reinvesting dividends and mutual fund loads. Both of these will cost you more money if you need to pay to reinvest the dividends or get hit with a sales fee. (The fee for reinvesting is different for every brokerage company, so ask.) Tally all the costs for each approach and select the cheapest long-term option. For example, if you are going to use a lump sum of money to add to your core index holdings that you will keep for at least 10 years, an ETF will allow you to pay one fee to get in with a much lower yearly management fee. That makes your costs less than a mutual fund's fees, which would have no upfront transaction fees but would come with a higher management rate over the long term. However, if you prefer to have your dividends automatically reinvested and your brokerage won't reinvest for free, then you might want to go with the index mutual fund that will automatically and for free reinvest the dividends.

Action to Take --> One final thought: I use the dividends from my ETF products to rebalance my portfolio; that way, I avoid automatic transaction fees. If I have to buy and sell to balance my portfolio, I transact two fees. However, if I use my dividends to change my allocations, I avoid the sales fee and just pay to buy.

This article originally appeared at InvestingAnswers.com
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