ETF vs stock are two instruments that have similarities and differences that investors must consider to ensure their financial decisions align with their investment strategies.
With so many financial instruments available to investors these days, it’s essential that investors understand what each product has to offer, the growth potential, and the risks. With hard-earned money at stake, increasing financial literacy is vital for making sound investment decisions in the optimal products to grow your wealth and meet financial goals.
Below is a deep dive into ETF vs stock to help you understand which type of investment is right for you.
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What is an ETF?
An ETF is an investment fund composed of a large pool of investments like stocks or bonds. ETFs are relatively new investment products compared to stocks, having been available since 1993 in the United States.
ETFs can range in size regarding the number of stocks in a single fund. Some ETFs are structured differently, primarily investing in commodities, currencies, and futures. There are also ETFs that hold stocks that can be specific to a particular sector (such as energy stock ETFs), by industry (like space stock ETFs) by index (representative of a market index such as the S&P 500), and by company size (a fund made up solely of large companies or small ones).
In 2020, ETF trading volume made up 26 percent of total stock market trading. With so many different ETF investment options available, investors can easily find a fund that fits their strategy.
What is a Stock?
A stock is a share in the ownership of a company. When a company sells shares of their stock, it allows them to raise capital outside of their usual revenue stream. In return, investors may earn a portion of a company’s profits through dividends. Investors may also gain if they can sell the stock higher than the purchase price.
Based on polls conducted by Gallup in 2021, 56% of Americans reported that they own stocks. This figure has been steady over the last few years but is below the 65% stock ownership level before the recession hit between 2007 and 2009.
ETF vs Stock Similarities
1. Buying and Selling
Both stocks and ETFs trade on stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq. Although ETFs appear to be structured similarly to mutual funds, one of the differences between the two is that ETFs experience price fluctuations throughout the day as shares are bought and sold on the market, just like stocks.
Unlike a stock, the number of shares outstanding of an ETF can change daily because shares are constantly being purchased and redeemed. Actively buying and selling shares keeps the market price of ETFs in line with their underlying securities.
Purchasing stocks or ETFs can be as simple as opening a brokerage account online, researching, and buying the number of shares of the stock of choice.
Many investors expect ETFs to be a good investment and also a low-cost one. When respondents were asked about the essential attributes of ETF products and strategies in a survey, 60% said that the low investment cost was the most important.
When you own stock in a company, you can receive a share of the company’s profits called dividends. The more shares you own of the company’s stock, the more share of the profits you are entitled to. Though many companies do, not all stocks pay dividends.
ETFs are usually created by brokerages, who purchase the stocks included in the fund. The brokerages then sell shares of the ETFs to investors. When the stocks in the ETF produce dividends, investors receive a portion of the total. With so many different stocks and bonds within the fund, an ETF will likely provide a steady income stream.
ETF vs Stock Differences
Investing in an individual stock is considered high risk because the value of the stock is directly tied to the performance of one company. Stock markets can be volatile, and stock prices can move quickly and by significant amounts. Investors need to hold several stocks and other investments to help diversify a portfolio from this risk.
The composition of many stocks within an ETF helps create diversification within the fund, so an ETF is unlikely to experience the volatility that a single stock can. However, there can be more risk if you own an industry-specific ETF such as the oil and gas industry which can be volatile. If the entire industry experiences a downturn such as when oil prices fall, the ETF could lose value.
Dwight Dettloff, CPA, CFP® of Winding Trail Financial Planning states,
“Using an ETF gives the investor diversification in allowing them to invest in multiple companies. Today, there are many ETFs to choose from including sector specific which allow for some diversification while at the same time the potential performance of that sector.”
2. Management Fee
Stocks don’t charge a management expense ratio. Investors monitor stock purchases on their own or hire a professional to manage a portfolio of investments. ETFs charge a management expense ratio (MER) to operate and manage the fund. Investors can choose to invest in an actively managed or passively managed ETF.
According to Danielle Miura, CFP®, the founder of Spark Financials,
“…ETFs, are professionally managed and are traded based on the goals of the fund. All the work of researching, buying, and selling is done on your behalf, usually for a low fee.”
However, a passively managed fund has a lower MER because it is less time-consuming to manage. For example, an ETF that tracks an index, such as the S&P 500, would contain the same 500 stocks as the index, so it’s easier to manage.
An actively managed ETF that requires managers to be more involved in buying and selling shares of companies and changing holdings within the fund would charge more.
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Should you Invest in an ETF or Stock?
Do You Like To Manage Your Investments Actively?
When investing in a stock, you buy shares of a single company. The company’s performance drives the gains and losses in share price. Therefore it is imperative that an investor knows and researches the company well. Many factors can influence a stock price, such as industry news and environmental and economic factors. Stockholders need to manage their investments actively.
Investors pay a management expense ratio for ETFs, so the fund is professionally managed.
ETFs can contain hundreds or thousands of stocks and bonds, so investors need to inform themselves of the industries, sectors, or index being tracked rather than the individual companies. However, ETFs are inherently more diversified, which is an advantage.
However, the disadvantage of ETFs is that an investors cannot control the stocks within the fund. Blaine Thiederman MBA, CFP®, the founder of Progress Wealth Management, says,
“The biggest con of ETFs is that you don’t have the ability to control what stocks you’re selling. You sell the whole index or nothing at all.”
What is Your Risk Tolerance?
Investing in ETFs can be less risky than investing in individual stocks because an ETF offers diversification by investing in hundreds or thousands of stocks and bonds in one fund. Of course, this applies more to ETFs that track an index or contain thousands of stocks to spread the risk rather than riskier industry or sector-specific options.
David Edmisten, CFP®, the founded of Next Phase Financial Planning, says,
“By using ETF’s, we eliminate company and sector specific risks by being diversified. At any time, an individual company stock can perform very differently (either better or worse) than the general stock market or economic trends. This introduces a level of risk for the investor…”
But the return potential can also be lower than stocks. Stocks are high risk but can also earn you higher rewards. Other risks include liquidity risk if the stock can’t be bought or sold easily, foreign exchange risk for fluctuating currencies and interest rate risk – higher rates mean higher borrowing costs for companies.
Conclusion ETF vs Stock: Where Should You Invest?
If you like to thoroughly research and actively manage your investments and can tolerate the high-risk yet potential high-returns that stocks provide, consider investing in stocks instead of ETFs.
ETFs can offer diversification, an income stream, and lower risk, especially when tracking a broad and core market index. With the U.S. ETFs growing to $5.4 trillion in total net assets in 2020, making them the largest globally, many investors are recognizing the benefits of investing in exchange-traded funds.
You can also read Is $1 Million Enough to Retire by the same author.
Related Articles on Dividend Power
- ETF vs. Index Fund: Which Is Best for Your Portfolio?
- ETF vs. Mutual Fund: Which Investment Is Right For You?
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Nadia Tahir is a freelance writer and content creator. She mostly writes in the areas of lifestyle and personal finance. She also enjoys writing on her blog about motherhood at This Mom is On Fire.