Thinking about investing in stocks? You can trade two main types of stock securities: individual stocks and exchange-traded funds (ETFs). What are the advantages and disadvantages of ETFs vs. stocks? And how do you know which one is right for you? In this investor’s guide, we will cover what stocks and ETFs are, their pros and cons, and when you should consider investing in them.
What is a Stock?
A stock is a share of a company that entitles you to a portion of the company’s profits.
Stocks are primarily issued as a fundraising method for the company. Let’s say that a company wants to raise money for a new enterprise. For instance, an electronics company decides to create a new line of state-of-the-art computers.
The company will need lots of money to launch its new products. It’ll need extra cash for research and development, product design, manufacturing, and marketing. To raise all that capital, the company issues new shares—stocks.
You—an investor—say to yourself, “Hey! I think this company has good leadership, creates good products, and is going to increase its profit margin over the next several years.” So you decide to purchase stock in the company. The company uses your payment to help finance its new product line. In return, you’ll receive a share of the company’s profits. Hopefully, the new product line will be a huge success, and your earnings will increase as the company grows more profitable.
The portion of the company’s profits that are paid to you is known as a “dividend.” Companies may pay out dividends monthly, quarterly, or annually. The terms are stipulated when you purchase your first share. The more shares you own, the higher your dividends will be.
Note: A stock doesn’t give you actual ownership over the company—it only gives you a portion of the company’s profits.
This structure is good for two reasons. First, it legally separates the company and the investors so that neither party can terminate the other’s assets. Second, it provides incentives for investors to keep putting money into the company (so they can increase their share of profits).
You can purchase stocks directly from the company, but most stocks are bought and sold on a stock exchange. A stock exchange is a marketplace for securities, like stocks, bonds, and mutual funds.
To start buying and selling, all you need to do is open an account at a brokerage firm. A broker acts as a middleman when you’re buying or selling shares. You’ll pay a small fee for each transaction you order, but it’s the fastest and most convenient way to purchase stocks. Most investors purchase multiple securities in a single transaction so that they don’t pay as much in fees.
It’s important to note that a corporate stock is not the same as a corporate bond. A corporate bond is referred to as a “fixed-income security.” Think of it as a type of loan that you give a company. You’re going to provide the company with more money up-front, and the company will repay that money to you in predetermined increments. You’ll get all your money back, plus monthly or annual interest.
A corporate stock works differently. With corporate stocks, the dividends you earn may fluctuate in value, depending on how much the company is earning. Your shares will be more valuable and produce higher dividends when the company is doing very well. When the company is floundering, your shares may become less valuable and produce lower dividends.
We’ll discuss this in more detail later on.
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What is an ETF?
An exchange traded fund (commonly referred to as an “ETF”) is a basket of stocks. A single ETF may contain hundreds, if not thousands, of different stocks. But you can also find ETFs that only contain a small number of stocks.
ETFs are not issued by a single company like stocks are. Most ETFs are created by financial firms, such as brokerages. First, a brokerage purchases all the stocks that are going to be included in the fund. All the stocks in the fund will produce dividends and possibly even interest payments.
The brokerage then sells shares of the ETF to investors. When you’re an ETF shareholder, you’ll receive a portion of the ETF’s profits. That might sound like a massive sum of money, but remember that ETFs often have hundreds, if not thousands of other investors that you’ll be splitting profits with (just like with a corporation). But you can always buy more shares of the ETF, so you increase your earnings.
ETFs are bought and sold on stock exchanges, just like stocks and other types of securities. You only need to open an account at a brokerage firm to begin buying and selling.
When you purchase an ETF, you don’t own any of the stocks included in the fund. You only own a portion of the profits. It’s like being a shareholder of a corporation.
An ETF may be actively or passively managed. Actively managed ETFs are overseen by an investment manager. The investment manager is constantly overseeing the performance of the stocks within the fund and may swap out poorly performing stocks with more highly performing ones. Actively managed ETFs usually have higher fees due to the presence of an investment manager, but they might perform better over a shorter period.
A passively managed ETF does not have any investment manager overseeing the fund, so they tend to be less expensive. While a passively managed ETF may not yield higher dividends than an actively managed ETF, the lower cost ratio often makes it more profitable for investors over a longer period.
An ETF may also target a specific kind of stock:
By Sector: The ETF may contain stocks only within a particular industry, like technology, medicine, or entertainment.
By Index: These ETFs (called “index ETFs”) hold stocks that are representative of an entire market index (like the S&P 500, for example).
By Company Size: Some ETFs may contain stocks from very large companies, while others may contain stocks from smaller companies.
ETF vs. Stock: The Similarities
Both ETFs and stocks are traded during the day on stock exchanges. Thus, both types of securities have “high liquidity.” That means that both ETFs and stocks are relatively easy to buy or sell at a moment’s notice.
Liquidity isn’t something that long-term investors are usually concerned with because long-term investors tend to keep their holdings for a long time. They don’t sell their shares very frequently. But if you’re interested in active trading, the liquidity of ETFs and stocks is essential. You need to be able to buy or sell quickly so you can take advantage of good prices when you see them (a high price if you’re selling or a low price if you’re buying).
Index funds, mutual funds, and individual bonds don’t trade quite as easily or quickly as ETFs or stocks do, and there’s less transparency about what the price is going to be when your order is processed at the end of the trading day.
Additionally, both stocks and ETFs pay dividends.
ETF vs. Stock: The Differences
Aside from the fact that both ETFs and stocks have high liquidity, there are some major differences between the two types of securities. Here are the most important differences that you need to know.
1. Number of Shares
When a company issues stocks, only a fixed number of shares are issued. The number of shares doesn’t change very often, save for the occasional stock buyback or stock split—but those are rare occurrences.
ETFs, on the other hand, attempt to accurately match the average share price of the stocks included in the fund (called the “net asset value”). To do this, the ETF uses a process called “creation and redemption.” Essentially, the ETF adjusts the number of shares in the fund to lower or raise the value.
So how exactly does that affect investors? It makes it more difficult—in theory—to outperform the market with an ETF than with individual stocks.
2. ETFs Can Provide Diversification
Most investors want to create a diverse investment portfolio, which means they’ve invested in a variety of different assets. For example, a diverse investment portfolio might include stocks, bonds, mutual funds, and real estate. Diversification is helpful because it lessens the chance that a downward swing in one particular sector will destroy your investment earnings.
Some types of ETFs can provide you with a substantial amount of diversity. Specifically, the ETFs that contain stocks from a variety of different industries (for instance, an index ETF representing the S&P 500).
Not all ETFs will provide you with diversity. Like those representing only a single industry, highly focused ETFs may only provide as much diversification as an individual stock.
Risks of ETFs vs. Stocks
Not everyone invests in the stock market because it is volatile. In other words, it can be risky. There’s also the risk of inflation, interest rate, and liquidity. However, some people are lucky are make smart choices and get high returns on their investments, making it worthwhile.
ETFs are slightly less risky because they are a small basket of investments. This means that risk is diversified amongst the various energy sources held in the ETF. However, take care to investigate what is held in the ETF. For example, if you invested in an oil and gas ETF, the risk is essentially the same as a single stock. That’s because the oil and gas markets belong to the same industry, and their performance parallel one another. An ETF might spread out risk by holding different types of energy sources, or by spreading their holdings across different international markets.
When to Invest in Stocks
Stocks might be a good investment option for you if:
You have high risk tolerance
You’re trying to round out your investment portfolio
You’re trying to outperform the market
Individual stocks are high-risk investments. It’s very difficult (if not impossible) to determine whether a company’s stock will yield high returns. If a company is performing poorly, you could suffer big losses on your investment. And even if a company is performing very well, a surprise economic recession could still damage your earnings.
Still, your investment could yield very high earnings if you happen to pick the right company, so if you’re an investor who’s okay with “high-risk, high-reward” ventures, then stocks might be a good option for you.
Stocks are a good option for any investor who’s trying to build a diverse investment portfolio. The bulk of your portfolio might consist of low-risk investments, like index funds or bonds. A smaller portion of your portfolio might consist of medium-risk investments, like investment properties or ETFs. You can dedicate the smallest portion of your portfolio to high-risk assets, like individual stocks. Even if your stock investments don’t turn a profit, you’ll still be earning money from your other investments.
And who knows? There’s always a slim chance that you’ll invest in the next Google or Amazon. Individual stocks present the opportunity to outperform the market by a wide margin if you invest in the right company or if you’re a savvy day trader.
When to Invest in ETFs
An ETF might be a higher-priority investment for you if:
You have less risk tolerance
You’re a long-term investor
You’re seeking diversification
ETFs are less risky than individual stocks. Since there are various stocks included within a single fund, it’s more likely that an underperforming stock will be compensated for by other stocks that are doing well. You’re probably not going to see price swings that are as high or dramatic as individual stocks.
However, that also means you have a lower ceiling, so far as returns are concerned. If there are stocks in the fund that are performing extremely well, they could be offset by poorly performing stocks. And your dividends will almost always be lower than the highest performing stocks in the fund.
But the stability of an ETF is an attractive characteristic for long-term investors, especially those who are saving for retirement. Long-term investors aren’t worried about week-to-week or even month-to-month price swings. They’re only trying to earn steadily-increasing earnings over a long period, and ETFs are well-suited for that endeavor given their reliability and low expense ratio (although a Roth IRA or 401(k) might be better retirement saving investments).
You don’t need to choose between ETFs and individual stocks. Both types of securities are beneficial to an investor trying to build out a diverse investment portfolio. And both types of securities are great for beginning investors who may not have as much capital to work with. If you open an account at an online brokerage firm, you could benefit from commission-free trading on stocks and ETFs (it’s offered by most online brokers).
Industries Where ETFs Are The Better Choice
ETFs are a great alternative investment choice when external factors driving a company’s performance are unclear. Great examples of this include biotechnology and other specialty technology, such as semiconductor, companies. For instance, if a new drug development is not approved by the Food and Drug Administration (FDA), then the company may not perform well. On the other hand, a newly approved drug could bring about high reward to investors. Investing into a sector overall, rather than a specific company, reduces risk. By investing in ETFs, you get to enjoy overall growth and developments in a sector.
What Is A Dividend ETF?
A dividend exchange-traded fund (ETF) is an investment asset that owns shares of companies with high-paying dividends. In essence, this allows you to invest in several high-yield companies at once. When choosing a dividend ETF, you’ll want to pay attention to its yield, growth, and durability. For example, if you’re a conservative investor, you might want to go with an ETF that features high returns over a sustained period instead of an ETF with riskier companies. Dividend ETFs present a balancing act between high yields, growth, and durability.
When considering ETFs vs. stocks, remember the following: A stock entitles an investor to a share of a company’s profits, while an exchange-traded fund (ETF) gives investors a share of a large basket of stocks. Both stocks and ETFs provide investors with dividends, and each is traded during the day on stock exchanges. Individual stocks are much riskier but can yield higher returns. ETFs are relatively low risk and provide stable, if less profitable, returns.
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