If you’re starting to invest, you may be wondering whether it’s better to invest in stocks or ETFs. Well, the answer depends. Stocks can be a great investment in some circumstances, while ETFs can be better in others. But for new investors, exchange-traded funds solve many problems, and they’re an easy way to earn attractive returns – so they’re a good place to start.
Here’s everything you need to know about stocks versus ETFs and when it’s best to use them.
Stocks and ETFs: How They Differ
It’s not surprising that stocks and ETFs are similar in some ways, since ETFs often hold many stocks. Despite their similarities, they are fundamentally different and carry different benefits and risks.
Shares
A share represents a fractional ownership interest in a company and is typically traded on an exchange, in the case of a publicly traded company. When you own stock, you are investing in the success of that company – and that company alone.
In the short term, stocks can rise and fall for many reasons, and market sentiment often determines how a stock performs on a day-to-day basis. However, in the long term, a share better follows the growth of the company. As the company increases its profits, its shares will also rise.
Individual stocks can perform phenomenally over time, but in the short term they can be volatile and fluctuate wildly. It’s not unusual for high-flying stocks to drop 50 percent in a given year on their way to longer-term outperformance. On the other hand, a strong stock can rise 50 percent or more in one year, especially if the market as a whole is popular.
ETFs
ETFs are collections of assets, often stocks, bonds or a combination of both. A single ETF can hold dozens, sometimes hundreds, of shares. Thus, by owning one share of the ETF, investors can own an indirect interest in all the shares (or other assets) held by the fund. It’s a great (and often cheap) way to buy a collection of stocks.
ETFs often invest in stocks that have a specific area of focus, such as large companies, bargain stocks, dividend-paying companies, or companies that operate in a specific sector, such as financial companies. You may be able to earn higher returns with some specialized ETFs.
Most ETFs are passively managed, meaning they replicate a specific index of assets, such as the S&P 500, a collection of hundreds of America’s largest companies. The ETF only changes its investments if the underlying index changes composition.
Because of their wide range of investments, ETFs offer the benefits of diversification, including lower risk and less volatility, making owning a fund often safer than individual stocks.
The return of an ETF depends on what it is invested in. The return of an ETF is the weighted average of all its investments. So if the ETF owns a lot of strong stocks, it will rise. If it owns a lot of underperforming stocks, the ETF will also fall.
The table below shows some of the key differences between stocks and ETFs.
| Characteristic | Shares | ETFs |
|---|---|---|
| Potential benefit | High | Low-high, depending on the investment |
| Risk | High | Low-high, depending on the investment |
| Lifetime | Potentially infinite | Potentially infinite |
| Brokerage commissions | No commission with major online brokers | No commission with major online brokers |
| When you can trade them | Every time the market is open | Every time the market is open |
| tax | May be taxed at short- or long-term capital gains rates, depending on holding period | May be taxed at short- or long-term capital gains rates, depending on holding period |
The pros and cons of shares
Investing in a stock can offer many advantages, but it also comes with some serious disadvantages.
Benefits of investing in shares
- Investing in individual stocks can yield very high returns, and you won’t be taxed on any capital gains until you sell them, in a taxable account.
- A single stock can potentially return much more than an ETF, where you receive the weighted average performance of the investments.
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Stocks can pay dividends, and over time those dividends can rise as the top companies increase their payouts.
- Companies can be acquired at a significant premium to the current stock price.
- Stock trading commissions have been reduced to zero at the major online brokers, meaning it costs nothing to get in and out of an investment.
- Investors who hold a stock for more than a year can enjoy lower capital gains tax rates.
- You can still own the wealth-building power of stocks within an ETF or mutual fund.
Disadvantages of investing in shares
- Stocks can fluctuate widely from day to day and month to month, meaning you may have to sell at a loss and may never get back what you invested.
- Volatility can be dangerous for investors who have all their wealth tied up in just one or a few stocks. If that one stock does poorly, the investor has many eggs in one basket and could lose a significant portion of his wealth.
- Stocks are not a government-guaranteed investment, so you could lose all your money.
- Because an individual stock tracks the company’s performance over time, you must own a winning company to make money. Pick a loser and you lose money.
- It takes a lot of effort to analyze and value individual stocks, and many people simply don’t have the time or inclination to do so.
- You have to pay taxes on the capital gains you generate, but you can also write off losses and get a tax break.
The pros and cons of ETFs
ETFs offer plenty of benefits to investors, whether they’re new to the game or more advanced, although these funds don’t come without some drawbacks.
Benefits of investing in ETFs
- With ETFs, you can buy one fund and take a stake in dozens or even thousands of companies.
- Because of this broad ownership, ETFs offer the power of diversification, reducing your risk and increasing your returns.
- A well-diversified ETF, such as one based on the S&P 500, can beat most investors over time, making it easy for regular investors to do well in the market.
- ETFs tend to be less volatile than individual stocks, meaning your investment won’t fluctuate in value as much.
- The best ETFs have low expense ratios, which are the fund’s costs as a percentage of your investment. The best ones may only charge a few dollars per year for every $10,000 invested.
- ETFs can be bought and sold anytime the market is open, giving you a highly liquid asset.
- ETFs can be traded for free at most major online brokers.
- Little investment expertise is required to invest in ETFs and achieve high returns.
- You won’t be taxed on any capital gains until you sell the ETF in a taxable account.
- Like stocks, ETFs can pay dividends.
Disadvantages of investing in ETFs
- ETFs, even in a good year, will underperform the best stocks in the fund, meaning investors could have owned just those stocks and done better.
- ETFs charge an additional fee, the expense ratio, for owning the fund.
- Not all ETFs are the same, so investors need to understand what they own and what it could yield.
- Like stocks, the investment performance of ETFs is not guaranteed by the government and you may lose money on the investment.
- You have no control over what is invested in any fund, although you obviously don’t have to buy shares in that fund.
ETF vs. Stocks: Which is Better for Your Portfolio?
Buying individual stocks or ETFs can work better for individual investors in different scenarios, and here’s where each scenario excels:
When the stocks are better
- You enjoy analyzing and following individual companies. It takes a lot of work to follow a stock, understand its industry, analyze financial statements and track earnings. Many people do not want to spend this time.
- You want to find outperformers. If you can find the stocks that will outperform – Amazon or Microsoft, for example – you can beat the market and most ETFs.
- You are an advanced investor who has time to devote to investing. Many investors enjoy following companies and tracking them over time. If that’s you, buying individual stocks could be a good option for you.
When ETFs are better
- You don’t want to spend a lot of time investing. If you’re looking for a simple investing solution, ETFs can be an excellent choice. ETFs typically provide a diversified allocation to what you invest in (stocks, bonds, or both).
- You want to beat most investors, even the pros, with little effort. Buy an ETF based on the S&P 500 and you will beat the vast majority of investors over time. That’s right, passive investing with ETFs is generally better than active investing.
- You don’t want to analyze individual companies. If you don’t feel like tracking things, pick one or more ETFs and add to them over time.
- You are a new or intermediate investor. ETFs are great for novice investors and will help reduce your risk as your knowledge grows. But even many sophisticated investors use them too.
- You want to invest in a specific trend without picking winners. Is there a new industry, but you can’t decide which company will come out on top? Buy an ETF and get exposure to the entire sector at a low cost.
Of course, it is possible for investors to follow both strategies. For example, you might have 90 percent of your portfolio in ETFs and the rest in a few stocks that you like to follow. You can hone your skills in investing in individual stocks without much damage to your returns. When you’re ready, you can then move into more individual stocks and away from ETFs.
In short
ETFs are an excellent choice for many novice investors, as well as for those who simply don’t want to do all the legwork required to own individual stocks. While it’s possible to find the big winners among individual stocks, chances are you’ll do consistently well with ETFs. Of course, you can also combine the two methods, getting the benefits of a diversified portfolio with the potential added power of a few individual stocks to complement it, if you want to try out your skills.
Please note: Bank interest Rachel Christian also contributed to this story.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
