When it comes to stocks vs. ETFs, the difference is similar to buying a single flavor of La Croix versus a Costco variety pack. In other words, stocks offer shares in a single company, whereas ETFs offer shares in an assortment of them. And when it comes to choosing between the two, the good news is — both can help you build a solid portfolio.
What are stocks vs. ETFs, and how do you know which is right for you? Below we’ll give you all the details.
Stocks vs. ETFs: What’s the Difference?
Recall that companies issue stocks in order to raise funds, and investors buy them to have partial ownership in the company (and make money if the stock’s price goes up). Stocks are traded on an exchange, and their prices fluctuate constantly throughout the day.
Exchange-traded funds (ETFs)
An exchange-traded fund (ETF), on the other hand, is a professionally managed basket of investments. An ETF manager will typically buy investments from a range of asset classes — stocks, bonds, commodities — and sell shares of the fund to investors. This fund usually tracks a broader market trend or a sector in the economy, with the intention of matching its performance.
Because ETFs are professionally managed, they’re considered a more passive investment. Your fund manager will pick stocks and rebalance the portfolio for you. For the price of a single ETF share, you get instant diversification, as a single share will spread your money across numerous companies.
Stock investing, by contrast, involves a more hands-on investing approach. As a stock investor, you’re the manager of your own portfolio. You’ll research stocks on the market, pick the ones you think will perform the best, then buy shares through your brokerage. It’s hard work, but it’s hard work that has the potential to pay off splendidly.
If you pick the right companies, your gains could well outperform the broader market. An ETF can’t promise you that, as most exist to pace with the market, not beat it.
Of course, the losses in individual stocks can be big, too, which is why stock investing is considered more risky than ETFs. While, yes, you can lose money in an ETF, the built-in diversification typically blunts the downside losses with some upside gains. In order to diversify like this with stocks, you have to hand pick the right mix of companies yourself. It’s not impossible, but it’s more work for you.
Stocks vs. ETFs: How are They Similar?
Perhaps the biggest similarity between stocks and ETFs is how they’re traded: on an exchange. That means, you can trade both stocks and ETFs throughout the day, so long as the market is open. This is different from index funds and mutual funds (close cousins to ETFs), which are traded only after the market has closed and their prices have been finalized.
How to Choose Between Stocks and ETFs
Though nothing says you can’t invest in both stocks and ETFs, many investors, especially beginners, end up investing in one or the other. The reason is that stock investing typically appeals to one kind of investor (an active, hand-on one), whereas ETF investing appeals to another (passive, perhaps with less money to invest).
If you’re unsure which one is truly right for you, here are some questions to ask yourself.
1. Do you have time to research?
One of the most notable differences between stock investing and ETFs is research. As a stock investor, you’ll dedicate significantly more time to stock choices than ETFs. That could mean analyzing financial statements, hunting down undervalued stocks, or looking for start-ups with the potential for explosive growth. And, if you want a diversified portfolio, you’ll conduct in-depth research not once but numerous times.
With an ETF, you’ll spend far less time researching, as your ETF manager does the research for you. While you still want to analyze different ETFs to pick the best one, your research will be less intensive than stock picking.
2. Do you want more control over your portfolio?
Perhaps the biggest disadvantage to ETF investing is the lack of control you have over your stock choices. When you buy shares in an ETF, you’re at the mercy of the ETF manager. It’s their choice, not yours, to decide what’s included in an ETF’s holding.
For those investors who want to pick their own companies, especially companies that align with your values, stock investing has the upper hand. As a stock investor, you can build a portfolio of companies you feel strongly about, as well as exclude companies whose products, business models, or governance you don’t particularly care for.
3. How much risk are you willing to take?
It’s no secret that a solid portfolio of stocks has the potential to offer you a higher rate of return (ROI) than the overall market. But with that great potential comes greater risks, too. As a stock investor you’re pretty much on your own when it comes to building a portfolio. In your quest to outperform the market, you could very well underperform it. Not only that, but you could end up losing money on your stock choices.
For investors with a low risk tolerance, or don’t care to outperform the market, an ETF may be the right choice. ETFs have their ups and downs, too. But, over the long-run, ETFs have a much greater chance of doing what they promise: matching the market they follow. If you’re okay with average returns, an ETF will do the job nicely.
Stocks vs. ETFs: the Foolish Bottom Line
Stock investing is one of the best ways to build long-term wealth. With a portfolio of well-chosen stocks, you can average a rate of return that outpaces inflation and allows you to comfortably hit long-term savings goals.
Stocks, however, do require some time and research. If you’re just starting to invest, or you’re not ready to take on the risks of stocks just yet, a good quality ETF can help you get your feet wet in the investing world. A good ETF can give you a steady ROI over the long-term, too, helping you grow your money by the power of compound interest.
At the end of the day, you don’t have to pick one over the other. You can choose to invest in both. Maybe you like the security of an ETF, but you’d like to get more gains from individual stocks. Or maybe your ETF doesn’t contain shares of a company you believe has the potential to grow. Either way, you can easily create a well-balanced portfolio with both stocks and ETFs.