Two Asian women checking their stocks
Owning stocks is important for driving returns in a portfolio. But one question to consider is whether it makes more sense to invest in individual shares or an exchange-traded fund (ETF) that includes a basket of stocks. Choosing between an ETF and one or more stocks can depend on your risk tolerance and goals, as well as your preferences when it comes to taxes and investment fees. Both can help with diversification and increasing your exposure to different market sectors. Knowing what sets ETFs and stocks apart from one another can help you decide where they fit into your investment plan.
A financial advisor can help you gauge the relative risks entailed in buying a wide assortment of securities, not just stocks and ETFs.
What Is a Stock?
A stock represents an ownership share in a company. Publicly traded companies issue shares of stock for the first time through an initial public offering or IPO. When a company goes public, it just means its shares are available to buy and sell on an exchange like the New York Stock Exchange (NYSE). Each stock that’s traded is identifiable by a ticker symbol.
Stocks can also be referred to as equities. When you buy one or more shares of stock, what you’re getting is an equity stake in the underlying company. The value of that equity can increase or decrease over time as the stock’s share price rises or falls.
Publicly traded companies can issue shares of preferred stock or common stock. Preferred stock does not convey voting rights to shareholders, but it does offer consistent dividend payouts over time. Common stock shares can also offer dividends, though the amount and payout schedule may not be fixed. But investors who own common stock shares do get voting rights.
What Is an ETF?
An ETF represents a basket or collection of different securities. This basket can include stocks as well as bonds, cash and other investments. A fund manager is responsible for deciding what to hold inside the ETF and how to manage fund assets, according to a specific investment goal.
For example, some ETFs are dividend-focused, in that they hold securities that pay out dividends to investors. Others may track the movements of a particular index, such as the S&P 500, to try and mimic its performance. Index ETFs are passively managed, meaning the fund manager isn’t actively buying or selling underlying securities inside the fund.
Exchange-traded funds look and function largely like mutual funds, with one key difference. They can be traded on an exchange just like a stock. So compared to mutual funds, ETFs can offer more flexibility.
They can also be less expensive in terms of the expense ratio you pay to own them. Passively managed index funds, for example, can have expense ratios that are much lower than traditional actively managed mutual funds. This can make them cost-efficient while their lower turnover ratio can also make them more tax-efficient as well since there are fewer capital gains tax events to worry about.
Pros and Cons of Stock Investing
Investors discuss ETFs
Financial experts tend to agree that investors who are interested in building wealth need to own some stocks. Compared to bonds, for example, stocks can produce higher returns over time. The more time you have to invest, the more your stock portfolio can grow through the power of compounding. That’s arguably the biggest pro in favor of stock investing. But other advantages include:
Diversification and the ability to manage risk
Potential to earn dividends for income or to reinvest in additional shares of stock
Liquidity and the ease with which stock shares can be converted to cash
On the con side, there are two key drawbacks to consider. The first is risk.
Stocks and the stock market are susceptible to volatility. The market environment during the first part of 2020 was a great example of how quickly stock prices can dip because of things that are completely outside an investor’s control. But after an initial period of instability and price drops, stocks began to rebound.
Taxes are another consideration. When you sell individual shares of stock at a profit you’ll pay capital gains tax. If you’re an active day trader who frequently buys and sells, you may owe the higher short-term capital gains tax rate.
Buy and hold investors can take advantage of the more favorable long-term capital gains tax rate. But if you own dividend stocks, you’ll have to report dividend payouts as income each year, which could affect your tax bill.
Pros and Cons of ETFs
Exchange-traded funds mirror stocks in a lot of ways, though the biggest difference obviously is that you’re owning multiple securities vs. just one. Some of the other benefits of ETFs include:
Diversification across sectors with a single investment
Index tracking if you prefer index ETFs to other types of funds
Low minimum investments
Investing in ETFs could be more affordable than investing in stocks, depending on what you want to own. For example, say you’ve got your eye on a top tech company that’s trading at $1,000 a share. If you only have $1,000 to invest then tying it all up in a single share of stock might not make sense.
On the other hand, you might be able to invest in an ETF that owns that stock, along with other top tech stocks, with as little as $100 or even less. Online brokerages can offer access to ETFs through taxable investment accounts with low minimum deposit requirements.
Compared to stocks, ETFs can be a little less risky since you’re spreading risk out across multiple securities. One thing you do have to be careful of, however, is owning multiple ETFs that include overlapping investments.
For example, say you buy an index ETF that tracks the S&P 500. You also buy an ETF that mainly holds large-cap U.S. companies. Because the S&P 500 tracks the largest companies, it’s possible that the underlying investments for the two ETFs could be similar. In which case, you might actually be increasing your risk rather than reducing it.
Should You Invest in an ETF vs. Stock?
Boxes labeled as various securities
Whether it’s better to invest in ETFs or stocks can depend on your overall investment strategy. For example, if you’re more of a hands-off investor who’s in the market for the long term then ETFs might be the better choice. You could build a complete investment portfolio around just a handful of ETFs and watch them appreciate in value over time. On the other hand, if you like to be more hands-on with investing, then trading individual stocks might be more appealing. This is the riskier option but it also has the potential for higher rewards if you’re investing wisely.
Before wading in with stocks or ETFs, consider:
Your timeline for investing
Whether you prefer an active or passive approach
What kind of returns you’re hoping to gain
Where you plan to hold investments (i.e. tax-advantaged plan such as a 401(k) or a brokerage account)
How much risk you’re comfortable taking on
Once you decide on whether to invest in stocks, ETFs or a combination of the two, you can move on to researching individual investments. This is where you’ll want to look at things like the risk profile, performance history and in the case of ETFs, the investment strategy and expense ratio.
The Bottom Line
While there are some differences between investing in an ETF and a stock, both can be a complement to a well-rounded portfolio. If you’re not sure which one to choose, think of it like this. Would you rather buy just one book or have access to an entire library? That’s a simple way to understand what it means to own a stock vs. ETF.
Tips for Investing
Consider talking to a financial advisor about where stocks and ETFs belong in your overall financial plan. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area. You just need to answer a few simple questions to get your personalized advisor recommendations online. If you’re ready, get started now.
Before you start investing, you will need to choose securities that suit your risk tolerance. You can determine your risk tolerance by evaluating your comfort level in certain investments.
Photo credit: ©iStock.com/Drazen_, ©iStock.com/ktasimarr, ©iStock.com/William_Potter
The post ETF vs. Stock: Key Differences appeared first on SmartAsset Blog.