When it comes to investing, there are a lot of different options to choose from. Two of the most popular investment vehicles are exchange-traded funds (ETFs) and stocks. Both have their pros and cons, so it can be difficult to decide which is the right investment for you.
Stocks have the potential to provide big profits, but they are also more risky and volatile. Many investors do not want to put their entire family farm on a single firm’s stock. That’s where ETFs come in. ETFs offer stability and diversification, but their upside is limited. So which one should you choose?
Differences between stocks vs. ETFs
By investing in a stock, you are buying a piece of a company that will be worth more or less in the future. When you buy an ETF, you are investing in many different stocks, bonds, or commodities.
A stock, also called a “share”, refers to a single unit of ownership in a company. When you buy shares of a company, you become a part-owner. As the company grows and becomes more profitable, the value of your shares increases.
However, stocks are volatile and can go up or down rapidly. A stock’s price is determined by supply and demand in the market. If more people want to buy the stock than sell it, the price goes up. The reverse is true if more people want to sell the stock than buy it.
In a bull market, individual stocks can perform exceptionally well, but in a bear market, they can lose a lot of value. During good times, it’s not uncommon for stocks to go up hundreds of per cent. But during bad times, stocks can half their value or more in a matter of days or weeks. For example, Amazon stock was performing incredibly well in the late 1990s but plummeted by 90% during the dot-com bubble. Of course, Amazon has since rebounded and is now one of the most valuable companies in the world.
An ETF is a collection of assets, typically stocks or bonds. Within a single ETF, you can own a little bit of each asset. For example, the Vanguard S&P 500 ETF (VOO) owns shares in 500 different companies.
When you invest in an ETF, you are buying a basket of assets all at once. This diversifies your investment and reduces risk because you are not relying on a single stock. Instead, you are investing in a group of them. If one stock goes down, the others might go up and offset the loss.
The downside of ETFs is that they typically do not outperform the market. They are designed to track an index, such as the S&P 500, and not to beat it. For example, from the beginning of 2018 to the end of 2021, the S&P500 returned about 74%. Meanwhile, Apple returned about 300%. Even though Apple is part of the S&P 500, the index was dragged down by other stocks that did not do as well.
Pros and cons of stocks
Individual stocks are still the most widely held financial asset, according to the U.S. Federal Reserve. Let’s take a look at some of the pros and cons of stock ownership.
Pros of stocks
- Higher potential returns: Stocks have the potential to make much higher returns than ETFs. Stocks can outrun the market in a bull market, and a group of stocks can rise more in value than the weighted average of an ETF that they’re part of.
- Better dividends: Stocks that pay dividends offer investors a way to receive regular payments from their investments. Dividends are not guaranteed, but dividend-paying stocks can pay out more than ETFs.
- Ownership control: BlackRock is buying ownership stakes in the firms it tracks, and other large ETF companies, such as Vanguard, are doing the same. When you buy stocks directly instead of through an ETF, you help distribute ownership more evenly, so big corporations don’t have too much control.
- Shareholder activism: When you buy stocks, you have the ability to vote on corporate matters and, in some cases, elect the board of directors. Investors with shareholder rights have a say in how the company is run.
- Thrills and spills: Researching stocks, analysing companies, and following their development from infancy to behemoths can be exciting. For some, it’s not a time-waster but an interesting and stimulating hobby.
Cons of stocks
- Higher potential for losses: While stocks offer the potential for higher returns, they also come with a greater risk of losses. It’s not uncommon for stocks to lose half their value or more in a bear market due to a company-specific regulation or other factors in the market change.
- Volatility: Stocks can be very volatile, which means their prices can go up or down a lot in a short period. They can also lay dormant for long periods and then make a sudden move in either direction. If your wealth is tied up in stocks, you may experience large swings in your net worth. Not everyone has the stomach to see their portfolio value go up and down.
- No safety net: If your investment goes south, there’s no compensation scheme like there is with an insured bank account. You could lose everything you put into a stock. This is also true for ETFs, but the risk of loss is spread out over a collection of assets, so it’s not as great.
- Everything on one horse: With an ETF, you’re investing in a bunch of different companies, so if one fails, it’s not the end of the world. But if you own just one stock and that company goes bankrupt, you could lose everything. Pick the winning horse or lose the race.
- Time-consuming effort: It takes a lot of time and effort to find, analyse, and monitor stocks. Not everyone has the knowledge, skills, or desire to do this.
Pros and cons of ETFs
ETFs are the fastest-growing type of financial investment, and there are good reasons for this. Here are the pros and cons of investing in ETFs compared to stocks.
Pros of ETFs
- Diversification: A globally diversified portfolio of low-cost index-based ETFs can spread your investment across multiple companies and countries, which can help reduce your risk and home-country bias.
- Less volatility: ETFs tend to be less volatile than individual stocks. This means they’re less likely to experience sudden, sharp losses in value. Of course, this also means they have the potential to make less of a return in a bull market.
- Don’t look for the needle in the haystack: Studies have shown that even professional stock pickers struggle to outperform the market over the long run. With a well-diversified ETF, you can get the market return without trying to find the needle.
- Lower risk: ETFs that track a stock index are generally seen as being lower risk than individual stocks. This is because they’re not as dependent on any one company. ETF companies are also subject to a lot of regulation and oversight.
- Less stressful: When the stock market crashes, it can be very stressful to see the value of your stocks go down. Some of them may never recover. When you invest in ETFs, you can still feel anxious, but you will feel better knowing that the ETF will eventually recover when the market turns around.
- Low cost: The largest ETFs have expense ratios below 0.20% per year, and in the U.S., there are even zero per cent ETFs available. Meaning, that it won’t cost you much to own an ETF.
- It’s passive: If you own a globally diversified portfolio of ETFs, you can set it and forget it. You don’t have to spend hours every week monitoring it.
Cons of ETFs
- Not all ETFs are equal: ETFs come in all shapes and sizes. Some are riskier than others. For example, there are ETFs that track volatile sectors such as biotech or marijuana stocks. There are also ETFs that use leverage, which can magnify gains and losses. So, it’s important to do your research before investing in an ETF. Many investors prefer an index-based fund like an S&P 500 ETF because these are neutral regarding the companies they follow.
- You can still lose money. ETFs are not risk-free. If the market crashes, your ETF will go down in value too. Bear markets can last for many years, and if you need to sell in a hurry, you may have to sell at a loss.
- Underperformance: Even during a good year, ETFs will not do as well as the best stocks in the fund. This means that if you had just invested in the top performers, you would have made more money.
- Concentration of power: By investing in stocks via an ETF, you’re essentially giving a large amount of power to the fund managers. They become major shareholders in the underlying companies and have a say in how they’re run.
- There is no safety net: ETFs, like stocks, are not insured by the government, and you may lose money on the investment.
Risks in stocks vs. ETFs
There is always a risk when you invest in something. But with stocks and ETFs, you can expect different levels of risk and reward. It’s important to understand these different profiles so you can make the best decision for yourself.
Risks in stocks
Stocks have concentrated risk. This means your money is tied to the success or failure of a single company or companies. If the company goes bankrupt, your investment is worthless.
Stocks are also volatile. This means their prices can go up and down a lot in a short period of time. This can be good if the stock price goes up, but it can also be bad if the stock price crashes and you need to sell. If your financial situation deteriorates in a bear market, you may have to sell your stocks at a loss and feel terrible about it if the market rebounds.
Stocks are also subject to market risk. This means that the entire stock market can go down, even if the company you’ve invested in is doing better than the market as a whole. While professional investors can rotate into bear market-proof stocks, the average investor often doesn’t have this knowledge or ability.
Risks in ETFs
ETFs have diversified risk. This means your money is spread out over a lot of different companies, so you’re not as affected if one company is doing poorly. However, a country-specific index-based ETF like an S&P 500 ETF will still have regional and political risks. A way to mitigate this is to invest in a global ETF which is not tied to one country.
Opportunity cost is another risk of investing in ETFs. This is when you miss out on gains because you’re invested in a fund that tracks the market instead of individual stocks. For example, if the tech sector is booming, but your ETF only tracks the S&P 500, you may not benefit as much as you would if you had invested individual tech stocks.
Picking the wrong ETF is also a risk. There are thousands of ETFs on the market: Electric vehicle ETFs, Clean Energy ETFs, Factor ETFs, etc. Picking one of these over an index-based ETF like the S&P 500 could lead to underperformance (or overperformance) if the sector you picked doesn’t do well (or if it does too well).
The bottom line
If you’re chasing big returns and are willing to take more risk, stocks might be the way to go. But if you want stability and diversification, ETFs might be a better option. There’s no right or wrong strategy. It all comes down to your risk tolerance and investment goals.
Picking stocks may make sense if you are confident in your ability to identify winners that can outperform the market by a wide margin. ETFs make a great choice if you just want to own a little bit of everything and let the market decide for you.
Of course, there’s no reason you can’t invest in both stocks and ETFs. Many investors do just that. By diversifying your portfolio into both classes, you can reduce risk while potentially squeezing the juice from a subset of winner stocks.
What are the pros and cons of ETFs vs. stocks?
The benefits of index-based ETFs are that they can be a low-cost way to get diversification and get the same returns as the market. The downside is that your ETF will not produce the same returns as the best stocks it holds. Stocks, on the other hand, offer the potential for higher returns, especially during good times, but they are also riskier.
How is an ETF different from a stock?
An ETF is a type of investment fund that owns a group of stocks, bonds, or other assets. They are traded on stock exchanges like regular stocks. An ETF is different from a stock because it represents a basket of securities rather than just one company.
Are ETFs riskier than stocks?
Some ETFs are just as risky as single stocks, but not all of them. For example, index-based ETFs that track broad markets are generally less risky than individual stocks. But there are also ETFs that track volatile sectors, which can be riskier than putting money in recognised, well-established, and financially sound companies.
Are ETFs good for beginners?
Yes, ETFs can be a good choice for beginner investors. They are often less expensive than mutual funds and provide diversification, which can help reduce risk. However, it’s important to do your research before investing in any ETF, as some are riskier than others.
Do ETFs pay dividends?
Most ETFs come in two varieties: those that pay dividends and those that don’t. Usually, one is called accumulating, and the other is called distributing. If you want to receive dividend payments, make sure to choose a distributing ETF.
How long do you hold ETFs?
You can hold an ETF for as long as you want, just like a stock. However, it’s important to remember that the value of your investment may go up or down over time. If you’re saving for retirement, you may want to consider rebalancing towards lower-risk income-producing investments as you get closer to your goal. Many sell their portfolio slowly as they approach or are in retirement to avoid having to sell during a market downturn.
Why are ETFs better than stocks?
ETFs are not necessarily better than stocks, but they can be a good choice for many investors. ETFs offer diversification, which can help reduce risk. They don’t require much maintenance, and they can be a low-cost way to get exposure to a variety of asset classes.