ETFs vs. Stocks: Which Is Better for You?
CS
Summary:
Investors can add both stocks and ETFs to their portfolios to gain access to the equity market, dividends, and capital appreciation. Stocks are better suited for experienced investors who are skilled at analyzing different stocks and rebalancing their portfolios as needed, while ETFs are often better suited for new investors with lower risk tolerance who want their investments managed for them.
Whether you’re new to the stock market or a seasoned investor, you may have wondered whether exchange-traded funds (ETFs) or stocks are a better investment. And as with any investment advice, the answer will depend on your individual financial goals. Each has its pros and cons, and in some cases, it may even be best to add both investment vehicles to your brokerage account.
Stocks tend to be the more complex option, as it takes time and energy to select individual stocks and build a balanced portfolio. In contrast, most ETFs offer a simpler option because they do much of the heavy lifting for an investor; in exchange for commissions, a team of professionals selects all the stocks for you.
Let’s take a closer look at the differences between stocks and ETFs to help you figure out which would be a better investment for you.
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What are stocks?
A stock is a share of ownership in a particular company. Investors on stock exchanges can only purchase stocks in publicly traded companies, while private companies can offer shares to their employees and select investors.
Being a shareholder in a publicly traded company comes with the benefits of ownership, including dividends, price appreciation, and, in some cases, voting rights. These benefits can increase an investor’s net worth.
Pros of stock trading
The following are some of the advantages of buying and selling stocks:
- Dividends — Dividends are distributions of profits from a company. Companies that pay dividends on their stocks can distribute them in the form of cash or reinvestment in additional stock.
- Capital appreciation — Capital appreciation refers to the growth in a stock’s market price over time. For example, if you buy a share in a company for $10 and the share’s price increases to $15 in a year, the capital appreciation on that stock would be $5.
- Voting rights — Depending on the type of shares you purchase, you may get voting rights to influence company decisions. These include mergers, board member elections, and other significant changes to the company.
- Commission-free trading — If you’re buying individual stocks on your own, you don’t need to pay commission fees to a professional to manage your portfolio for you.
Pro Tip
Capital gains from stocks will compound over time. In other words, every time a stock price increases by a given percentage, that capital appreciation can potentially increase in value as well. By reinvesting your dividends in the stock market, you can see your wealth grow exponentially over time.
Cons of stock trading
These are some of the downsides that come with buying and selling stocks:
- Lack of diversification — If you only invest in one stock, you could lose all your money if that company goes under. Diversification mitigates this investment risk by distributing your investments across multiple securities. Ideally, you should have at least 26 individual securities in your portfolio to achieve peak diversification, which can be challenging if you’re managing your portfolio yourself.
- Active trading risks — Investing involves risk, and stock picking has a notoriously poor track record. If even the most experienced investors and stock market analysts can’t always get it right, there’s a good chance you’ll lose money on at least some poorly performing stocks whenever you engage in active trading.
What are ETFs?
Exchange-traded funds (ETFs) are like mutual funds in that they pool a variety of individual securities. Most ETFs are index funds that are passively managed to track an underlying index, such as the S&P 500 or the Dow Jones Industrial Average, although actively managed funds and leveraged and inverse ETFs are growing in popularity. Unlike their mutual fund cousins, which only trade and update their net asset value at the end of the trading day, exchange-traded funds trade like stocks throughout the day.
Leveraged ETFs use debt and derivatives to either double or triple the daily return of an index. Inverse ETFs are similar, except they seek to mirror, not match, the daily return of an index. For example, if an index returned 1% on a given day, an inverse ETF would seek to return -1%. Note that these are not passively managed ETFs; they involve significant risk and are best suited to more knowledgeable and experienced investors.
Pros of ETF investing
The following are some of the advantages of ETF investing:
- Diversification — Compared to individual stocks, ETFs are considerably more diversified. Instead of owning stock in one company, a single fund can invest in hundreds or thousands of companies. This helps mitigate the non-systemic risk of one company underperforming or going out of business.
- Liquidity — ETFs have more liquidity than mutual funds due to their ability to trade intraday. While a mutual fund requires that you wait until the end of the trading day for a trade to go through, ETFs trade like stocks, so any market order entered during the day will trade immediately.
- Tax advantage — ETFs have a tax advantage over mutual funds: they do not pass capital gains on to investors the way mutual funds do, and thus they don’t create the same tax liability. Like investing in stocks, the only time an ETF holder must pay taxes on a capital gain is when they sell the ETF, which can lead to significant savings in the long run.
- Professional management — ETFs are managed by sponsors who choose the stocks based on the ETF’s mandate or investing rules and adjust the portfolio as needed. Having a portfolio managed by a team of managers and market analysts makes investing in ETFs much more accessible to beginning investors.
- Lower expense ratios — ETFs have lower expense ratios compared to mutual funds, especially in the case of an index fund. In 2020, the average equity mutual fund had an annual expense ratio of 0.5%, or $5 for every $1,000 invested. In contrast, the average equity ETF had a yearly expense ratio of 0.18%, or $1.80 for every $1,000 invested. Of course, when building your investment portfolio, it’s important to compare all fees across stocks and ETFs, as not all ETFs will be the cheapest option.
Pro Tip
Keep in mind that you cannot diversify away the systemic risk associated with investing; an economic crash will affect all investors across the market, regardless of the types of securities held. To mitigate this risk, make sure your financial plan also consists of safer options for growing wealth, such as a high-yield savings account and certificates of deposit.
Cons of ETF investing
These are some of the risks you face if you buy and sell ETFs:
- Management fees — Unlike individual stocks, ETFs are managed by a team of professionals, which means they usually come with commission fees. This can make ETF trading more expensive than buying and selling stocks on your own.
- Average gains — Even in its best year, the gains you earn from an ETF will be the average of all the stocks in the fund, which technically means it will always underperform its best stocks. Basically, you’ll be earning less from an actively managed fund than if you had simply bought those high-performing individual stocks yourself.
- Net asset value — The net asset value (NAV) of an ETF is the value of all the underlying securities held in the ETF. This value is calculated once per day based on the closing prices of the underlying securities. However, because the ETF trades throughout the day, it will always trade at a premium or discount to its net asset value based on market sentiment and volume. This means you risk buying above or selling below the NAV, which could hinder your gains compared to trading stocks individually.
ETFs vs. stocks: Which is right for you?
Now that we’ve gone over the pros and cons of stocks and ETFs, how do you decide which option is better for your portfolio? To answer that question, you need to have specific investment objectives in mind.
How experienced are you with investing? How high is your risk tolerance, and how comfortable are you managing that risk yourself? Are you looking for diversification and better risk management, or do you want more control over your portfolio’s investment weighting?
The following are a few scenarios that may help you decide whether stocks or ETFs are better for your investment portfolio:
Beginning investor
If you’re new to investing or have relatively little experience with the stock market, exchange-traded funds are likely the better option for you. ETFs provide investors with professional management and ample diversification, all with relatively low fees.
If you’re just starting to dip your toes into the world of investing, it’s highly recommended that you start with index funds. These come with low fees and are simple to understand and track.
Experienced investor with significant capital
If you have plenty of capital to invest and have experience researching and analyzing stocks and managing your own portfolio, individual stock investments may be better suited for you. As mentioned above, a stock portfolio should consist of at least 26 different stocks to achieve peak diversification, so as long as you have the capital to invest and the time to manage your portfolio yourself, you can achieve significantly higher gains than you would with an ETF.
To mitigate as much risk as possible, be sure to diversify your portfolio across asset classes (e.g., stocks, bonds, alternative investments), market capitalization, sector (e.g., tech, defense, utilities, real estate), and stock exchanges (e.g., U.S. markets, international markets, emerging markets).
Knowledgeable investor with limited time or desire to manage a portfolio
Maybe you’re a knowledgeable and experienced investor who understands how to effectively manage a stock portfolio, but you simply don’t have the time, energy, or desire to manage your own investments. In that case, your best option would be to invest in ETFs.
If your rick tolerance is on the higher end, you may want to consider investing in sector ETFs. If you invest a significant portion of your capital in a more volatile sector, like tech, you could potentially realize higher gains than you would with an index fund, all without putting in the work you would need to manage individual stocks yourself.
Pro Tip
If you’re still unsure whether you should invest in stocks or ETFs (or both), consider consulting with a financial advisor who can offer you the best investment advice. Use SuperMoney’s comparison tool to find the best investment advisor for you!
Should you invest in both stocks and ETFs?
Stocks and ETFs are both popular investment vehicles that potentially fit into your investment strategy, depending on your individual goals and financial situation. ETFs offer diversification and professional management, while individual stocks provide you with more flexibility and control to build a customized portfolio and realize advanced investment strategies like tax-loss harvesting and investment weighting.
Considering all this, your best option may be to invest in both stocks and ETFs to achieve an optimal level of diversification and flexibility for your portfolio. For example, you can invest in index funds to track the S&P 500 and the MSCI World Equal Weighted Index for large-cap U.S. and international investments, then buy individual stocks to diversify your portfolio with small-cap assets. With this investment strategy, you would be using ETFs for fixed-income investments and individual stocks for equity.
FAQ
What is an ETF?
An ETF is an investment vehicle that aggregates securities (stocks, bonds, etc.), similar to a mutual fund. However, unlike mutual funds, ETFs are traded on an exchange like stocks. Many ETFs track indices like the S&P 500, which helps keep their fees low.
Which is better for diversification: stocks, ETFs, or mutual funds?
ETFs are best for diversification, as they hold stocks, bonds, and other types of investments. For example, you could invest in four or five ETFs to build the same well-diversified portfolio that would require much more capital, research, and management to build with individual stocks.
Why should I choose individual stocks over ETFs?
Although they require more work to manage, individual stocks offer more flexibility than ETFs, as well as commission-free trading and voting rights to influence a company’s direction. Assuming you have enough time and capital to build a diversified stock portfolio, you could potentially realize higher gains from buying and selling stocks on your own as opposed to investing in an exchange-traded fund that’s managed for you.
Key Takeaways
- Stocks and exchange-traded funds are both popular investment vehicles that can be used to build wealth over time.
- Stocks are individual shares of ownership in a company and are traded throughout the day on stock exchanges. ETFs, like mutual funds, aggregate multiple types of investments into a single diversified fund.
- Stocks are better suited for experienced investors who have enough time, skill, and capital to manage their own portfolios, while ETFs are better suited for new investors seeking diversification and professional management.
- Whether you should invest in stocks or exchange-traded funds depends on whether you prioritize the flexibility and potential of stock trading or the diversification and hands-off approach of ETFs.
- You can also add both stocks and ETFs to your portfolio to achieve an even balance of diversification and flexibility for your investments.
CS
Chip Stapleton is a Series 7 and Series 66 license holder, CFA Level II candidate, and holds a Life, Accident, and Health Insurance License in Indiana. Chip received his Bachelor's in Saxophone and Physics from the Indiana University Jacobs School of Music in 2008. During his time there, he honed his mathematical and analytical skills. He received his Master's in Music Technology from Indiana University Purdue University—Indianapolis in 2010, where he was a Graduate Assistant. He is a financial advisor who enjoys the opportunity to train, develop, and support new advisors to build their own practices and help their clients achieve their goals. This included helping with case design, product knowledge, investment analysis, investment recommendation, portfolio construction, asset management, financial statement analysis, business planning, and business exit strategies.
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