Most investors typically have the same goal, to reach alpha. Alpha is an investment term used to describe a strategy that is outperforming the market and resulting in excess returns.
In other words, people invest to see their money grow and to generate wealth. There are several investing tools and strategies to consider if you’re looking to make an active return and one of the most common options is ETFs.
ETFs are exchange-traded funds and they are similar to stocks but also have some key differences. Let’s have a breif look at what ETFs and stocks are, and dive into their key differences and how these two options impact your investment strategy.
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What is an ETF?
An ETF, short for exchange-traded fund, represents a unique investment vehicle with distinct characteristics. ETFs are traded on stock markets and allow investors to acquire shares through taxable brokerage accounts or retirement funds. These investment options have gained popularity among novice investors due to their abundant availability.
In essence, an ETF can be likened to a well-diversified assortment of investments. For instance, an ETF may constitute of a blend of high-value stocks, municipal bonds, and exposure to precious metals. By purchasing shares of an ETF, investors obtain fractional ownership of the underlying investments, based on the specific composition of the fund.
The process of purchasing ETFs is relatively straightforward. They can be acquired in a manner akin to buying stocks, with a wide array of choices at hand.
What is a stock?
A stock is a form of ownership in a publicly-traded company, providing investors with rights and benefits such as dividends and voting privileges.
The nature and investment potential of stocks lie on their various characteristics, including ownership, dividends, risks and returns, classes, their market cap, sector and industry.
In addition, stocks can exhibit different levels of price volatility (some having significant price swings compared to others) and liquidity (some can be easily bought or sold compared to others).
Within the stocks' two most common categories - common stocks and preferred stocks, many other types exist.
Key differences between stocks and ETFs
Stocks represent a piece of ownership in a publicly traded company. ETFs are a bundle of assets and securities such as different stocks and bonds. A single ETF can contain dozens or hundreds of different stocks, or bonds or almost anything else considered an investable asset.
Since ETFs are more diversified, they tend to have a lower risk level than stocks. Similar to stocks, ETFs can be bought and traded at any time and they are also taxed at short-term or long-term capital gains rates.
The assets inside an ETFs are bought and pooled together by the fund’s managers. Shares of the fund itself are then an ETF bought and sold by investors on a stock market, like the New York Stock Exchange.
| ETFs | Stocks |
|---|---|
Group of securities including stocks and bonds. | Individual shares of a company. |
Risk is more diversified than a single stock, but not without risk. | Risk depends on the fortunes of the company. |
Can be more illiquid (depending on the fund). | More liquid. |
The pros and cons of stocks
Pros:
- Returns can be higher than ETFs: Even though stocks are generally a riskier investment, the returns can be greater, especially if the company is growing quickly.
- Commission-free trading options: There are many commission-free options that allow you to trade stocks without spending an extra penny.
- You’re not paying someone to manage your stocks because you are the manager.
Cons:
- Riskier investment: Investing in stocks is seen as a riskier investment than in a diversified fund because your capital is tied to the fortunes of a single company. With ETFs, especially indexed ETFs that contain tens or hundred of companies’ stocks, there is more diversity to help mitigate your risk.
- More effort: Picking winning stocks requires more effort in research and paying attention to continuing performance.
The pros and cons of ETFs
Pros:
- More diversified: With ETFs, you can buy one fund and gain access to stocks for several companies.
- Reduced risk: Since you’re investing in a variety of assets, ETFs can reduce your risk since you aren’t putting your eggs in one basket.
- As convenient as trading stocks: Buying shares of ETFs is as easy as buying shares of stock, and you can do it from your taxable brokerage account or a retirement account.
Cons:
- Less control over what you’re investing in: Since ETFs are pre-selected investment funds, you can’t pick and choose which specific stocks or bonds you’re investing in.
- May underperform stock investments: Even in a good year, an ETF based on a basket of stocks can underperform a single stock investment that is outperforming the market.
- Management fees: Even index ETFs have management fees, and actively traded ETFs’ management fees can be quite high. The management fee takes money out of your total return.
When picking stocks might work
Following stocks and analyzing the market takes a lot of time and effort. You’ll want to stay on top of market news, company updates, and really expand your knowledge on picking stocks in general. Famous stock investors like Warren Buffett usually give similar advice: buy shares of companies with a great business model, solid earnings and excellent management.
It’s impossible to tell the future or guarantee how certain stocks will perform. However, you can find some companies you feel comfortable investing in that have proven to be successful historically. This hands-on strategy could outperform the returns from ETFs if you’re able to be dedicated to it.
When an exchange-traded fund (ETF) might be the Best choice
Investing in ETFs is the better choice if you want to diversify your holdings to reduce risk. Perhaps you’re not interested in poring through company quarterly reports and investing newsletters and would rather have someone else pick and manage your holdings.
ETFs still perform well and can even beat out stocks and hands-on investors with very little effort on your part. You should still be willing to research different ETF options, but you don’t have to be so concerned about picking “winners” as such.
With either stocks or ETFs, you do want to get advice from a financial advisor to help you not only pick investments but also manage your tax exposure and your long-term strategy and goals. WiserAdvisor can point you to a qualified professional to guide you.
Find the right financial advisor with WiserAdvisor
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WiserAdvisor.com is a free, independent and unbiased matching service that helps individuals find and connect with the best financial advisor for their needs. Qualified consumers are provided a personalized match with 2-3 vetted advisors to compare.
Stocks and ETFs aren’t either/or, they’re both/and
When it comes to stocks vs. ETFs, one is not better than the other. They are both solid ways to invest your money depending on your interest and goals. In fact, you can do both to further diversify your portfolio.
Knowing how both stocks and ETFs work as well as the core differences between the two can help you make a wise decision for your strategy.
Frequently asked questions (FAQs)
Are ETFs good for beginners?
ETFs are a solid option for beginners due to their low expense ratio and diversity. ETFs are also a more liquid investment and have a very low investment threshold.
Do I need to pay taxes on ETFs?
Yes, when you sell shares of an ETF for profit, you’ll owe taxes on the “realized gain.” A realized gain is a return on an investment that indicates it was sold at a higher price than what it was originally paid for. You may also have to pay taxes on income from an ETF if it pays a dividend.
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Alpha and Investment Goals
Investors typically aim to achieve alpha, which refers to a strategy that outperforms the market and generates excess returns. The goal of investing is to see one's money grow and generate wealth [[1]].
ETFs and Stocks
ETFs (exchange-traded funds) and stocks are both investment options, but they have some key differences.
- ETFs are investment funds that are traded on stock markets. They allow investors to acquire shares through taxable brokerage accounts or retirement funds. ETFs are often well-diversified portfolios that can include a blend of stocks, bonds, and other assets. By purchasing shares of an ETF, investors obtain fractional ownership of the underlying investments [[2]].
- Stocks represent ownership in a publicly-traded company. When you buy shares of a stock, you become a shareholder and have certain rights and benefits, such as dividends and voting privileges. Stocks can vary in terms of price volatility, liquidity, and other characteristics [[3]].
Key Differences between ETFs and Stocks
Here are some key differences between ETFs and stocks:
- Diversification: ETFs are typically more diversified than individual stocks because they can include a variety of assets. This diversification can help reduce risk [[4]].
- Risk Level: ETFs tend to have a lower risk level compared to individual stocks due to their diversified nature [[4]].
- Liquidity: Both ETFs and stocks can be bought and traded at any time, but the liquidity of specific ETFs or stocks can vary [[4]].
- Investment Composition: ETFs are composed of a group of securities, including stocks and bonds, while stocks represent individual shares of a company [[2]] [[3]].
- Control and Selection: With ETFs, you can't pick and choose specific stocks or bonds to invest in, as they are pre-selected investment funds. With stocks, you have more control over the specific companies you invest in [[5]].
- Management Fees: ETFs, even index ETFs, have management fees, which can impact your total return. Stocks, on the other hand, do not have management fees [[5]].
Pros and Cons of Stocks and ETFs
Here are some pros and cons of investing in stocks and ETFs:
Stocks:
- Pros: Potential for higher returns, commission-free trading options, and direct control over your investments [[6]].
- Cons: Higher risk, more effort required for research and monitoring, and your capital is tied to the fortunes of a single company [[6]].
ETFs:
- Pros: Diversification, reduced risk, convenience of trading, and access to a variety of assets with a single fund [[7]].
- Cons: Less control over specific investments, potential underperformance compared to individual stocks, and management fees [[7]].
When to Consider Picking Stocks or Investing in ETFs
- Picking Stocks: If you have the time, knowledge, and dedication to research and analyze individual companies, picking stocks might be a suitable strategy. This approach requires staying informed about market news, company updates, and understanding the fundamentals of successful companies [[8]].
- Investing in ETFs: ETFs are a better choice if you want to diversify your holdings to reduce risk and prefer someone else to manage your investments. ETFs can still perform well and may even outperform stocks with minimal effort on your part. Researching different ETF options is still important, but you don't have to worry about picking individual winners [[9]].
Conclusion
Both stocks and ETFs have their advantages and disadvantages, and the choice between them depends on your investment goals, risk tolerance, and personal preferences. It's always a good idea to consult with a financial advisor who can provide personalized guidance based on your specific needs and circ*mstances.
I hope this information helps you understand the concepts mentioned in the article. If you have any further questions, feel free to ask!
