Two of the most popular ways to invest in the stock market are individual stocks and ETFs (exchange-traded funds). Each has its own advantages and disadvantages, but which is the right choice for your portfolio?
We’re going to dive into the differences and similarities between stocks and ETFs, as well as the pros and cons of each, and how and when to invest in one or the other – or even both.
Differences and similarities between stocks and ETFs
Stocks and ETFs share a lot of similarities. But because ETFs are funds, they’re generally more varied and flexible than individual stocks.
Differences
Stocks represent an ownership share in a single company. By contrast, an ETF represents ownership in many different companies.
Beyond the number of securities represented, ETFs can also hold more than stocks. For example, it’s common for ETFs to hold bonds and other securities. In that way, owning shares in a couple of stock ETFs, as well as one or more bond ETFs, can provide you with a balanced portfolio with minimal effort and management on your part.
Most ETFs are what are known as index funds. These are funds that invest in a portfolio matching a popular index. Examples include the S&P 500 index and the NASDAQ 100 index. But an ETF can also invest in an index based on specific industry sectors, stock types (growth, income, or value stocks), or even regional markets.
If an ETF is based on an index, it will also be more tax-efficient. That’s because index-based funds engage in very little trading. And when they do, they mostly generate long-term capital gains, with their lower tax rates.
Similarities
Both stocks and ETFs (or stock ETFs, at least) are invested in equities. The main difference, however, is that while a single share of stock represents a single company, a single share in an ETF can include thousands of companies.
Both security types trade on popular exchanges, in share form. That means you can buy a single share, 100 shares, or only a fractional share of either an individual stock or an ETF. And because they trade on popular exchanges, either can be bought and sold quickly and easily.
And in today’s competitive investment brokerage industry, both securities are available for commission-free trading. Either can also be held in a taxable brokerage account or a tax-sheltered retirement plan, like an IRA or a 401(k) plan.
Stocks pros and cons
Pros:
- Stocks represent direct ownership in a specific company.
- You can choose the companies you want to invest in.
- Individual stocks, and small groups of individual stocks, often outperform ETFs.
- Stocks, unlike ETFs, don’t have expense ratios.
- Stocks now commonly trade commission-free with most investment brokers.
- It is possible to diversify a small amount of money across many different stocks using fractional shares.
Cons:
- The success of any investment in a single stock is dependent on the investor’s knowledge of the company, its industry, and the state of the market.
- Managing a stock portfolio is a hands-on activity.
- It’s extremely difficult to identify stocks likely to outperform the market over the long term.
- Diversification can be difficult to achieve, since it may require holding 20 or more stocks that, in combination, have a reasonable level of safety.
- The risk of loss on any individual stock is considerably greater than that of an ETF.
- Tax consequences can be significant for traders who generate short-term gains.
- Even stocks in “good companies” can fall at any time, sometimes dramatically.
ETFs pro and cons
Pros:
- Ability to invest in an entire portfolio of stocks or other securities.
- Small upfront investment, typically the cost of a single share or even a fractional share.
- Very low expense ratios, often below 0.20% per year.
- Like stocks, ETFs commonly trade commission-free.
- Available through most investment brokers, and commonly included in robo-advisor portfolios.
- Shares are highly liquid since ETFs trade on major stock exchanges.
- Highly specialized funds enable you to invest in specific industry sectors, security types, and even geographic locations.
- Index-based ETFs are tax-efficient since they trade infrequently and primarily generate tax-favored long-term capital gains.
- ETFs are the perfect vehicle for someone who wants to invest in the stock market but doesn’t know much about individual stocks.
Cons:
- ETFs have expense ratios, which stocks do not.
- Investors have no control over the stocks held in a fund.
- Index-based ETFs are designed to match the market, but not to outperform it.
- Investors often invest in multiple ETFs, which is not entirely unlike building and managing a portfolio of individual stocks.
- ETFs are not immune to market downturns.
When should you invest in either one or even both?
Individual stocks can be the better investment choice if you are an experienced investor with a proven track record of making winning stock picks. “Winning stocks”, refers to those that outperform the general market. It’s the classic high-reward/high-risk arrangement specifically designed to outperform the market.
You should also have a higher-than-average risk tolerance. That means you’re prepared to live with the potential losses that individual stock investing can generate. One way to determine this risk tolerance is by taking the Vanguard Investor Questionnaire. It will ask you a series of questions that will determine if you are a conservative or very aggressive investor, or at some level in between.
If you are on the more aggressive end of the scale, stocks may be the right choice for you. But if you fall in the conservative-to-moderate range, ETFs will probably be the better choice.
When ETFs make sense
If you’re a new or intermediate investor, or if you have a low or moderate risk tolerance, ETFs are likely the better choice for you. They will also work better if you prefer hands-off investing. All you need to do is fund your ETF(s) and let the fund handle all the investment management. That will leave you free to take care of every other area in your life, without needing to invest time in your portfolio.
When both stocks and ETFs make sense
As many investors have found, investing in both stocks and ETFs is often a winning strategy. This is especially true for intermediate investors, who prefer keeping the bulk of their portfolios in funds but want to begin gradually investing in individual stocks.
That setup can allow you to increase your individual stock exposure as you become more comfortable with the process. If you become a successful individual stock investor, you may eventually build a portfolio composed entirely of individual stocks.
But you may also spend the rest of your life investing in both, as you attempt to create the right balance between risk and reward.
How to buy ETFs or stocks
Both stocks and ETFs can easily be purchased through investment brokers and, in the case of ETFs, through robo-advisors. You’ll need to open an account, fund it, and choose your investments. Whether it’s stocks or ETFs, you can invest for as little as the cost of a single share, or even less if you purchase fractional shares.
Companies to consider investing through include:
Investment brokers
TradeStation isn’t one of the better-known brokers in the industry, but it is one of the best. You can trade stocks, options, and more than 2,000 ETFs commission-free. But you could also invest in futures, futures options, options, and crypto, all on the same platform. The company has an excellent trading platform and one of the better customer service desks in the industry.
Charles Schwab is a full-service investment platform, with discount prices. They offer commission-free trades in stocks, options, and thousands of ETFs. It’s an especially good platform for new and inexperienced investors since it offers award-winning 24/7 customer service and even a network of brick-and-mortar branches across the country.
Fidelity is very similar to Charles Schwab in its product offerings, commission-free trading of stocks and ETFs, 24/7 customer service, and hundreds of branch offices around the country. Fidelity is also one of the largest issuers of funds in the industry, making it a particularly good choice if you want to invest in funds, rather than individual stocks.
Robo-advisors
M1 Finance differs from the other platforms in that it’s a robo-advisor, but one that allows you to choose the investments you will make. Though they do provide portfolio templates, you can build your own portfolios – called “pies” – filling each with a mix of up to 100 ETFs and/or individual stocks.
Once you build your pies, they will be automatically managed by M1 Finance, with no annual advisory fee. You can open an account with no money at all, then begin investing with as little as $100.
Managed investment portfolio
Empower isn’t an investment platform, but an investment management service. Though it isn’t specifically a robo-advisor, it does use automated investment management tools in conjunction with human investment advice and management. You’ll even have access to a dedicated financial advisor.
It’s perfect for investors with larger portfolios, who don’t want to pay the high annual fees of traditional investment advisors. You can begin investing with as little as $100,000, and an annual advisory fee starting at 0.89%. That’s well below the 1% to 1.5% commonly charged by traditional investment advisors.
Frequently asked questions (FAQs)
Are ETFs riskier than stocks?
Though ETFs can lose money, they are still considered less risky than stocks. That’s because instead of holding a few individual stocks, an ETF can hold hundreds or even thousands. The diversification across so many securities lowers the impact of losses generated by any single stock, or even a small group of stocks.
Are ETFs good for beginners?
Yes, in fact, they are a frequently recommended option for new investors. That’s because they give you an opportunity to invest in stocks and other asset classes through widely diversified funds. You can invest a small amount of money, enjoy significant diversification, and enjoy very low annual fees.
ETFs may be the closest thing to a “fire and forget” investment. You invest your money, which is managed by the fund, and go about tending to the rest of your life. Your only responsibility will be to fund your ETFs and watch them grow over time.
How long should you hold an ETF?
Just as is the case with stocks, the best results typically come to those who hold their positions for many years. Since ETFs are investments in entire markets, and those markets tend to rise over time, they are the perfect vehicle for buy-and-hold investing.
As you hold your investment, you’ll enjoy compounding investment returns. For example, a $1,000 investment in an ETF, with an average annual return of 8%, will grow to $2,159 in 10 years, $4,661 in 20 years, and $10,063 after 30 years. That’s a 10-to-1 return with no extra effort on your part.
