With free trading apps like Robinhood and effortless investment options like Betterment, more and more people are interested in investment.
It doesn’t take long before you run into something called an “ETF” or “Exchange-traded Fund.” So, how are ETFs and individual stocks the same and different?
Which one is “better?” We’ll attempt to answer those questions now!
What Is an Exchange-Traded Fund?
For those who may not know, let’s start from the very beginning: what is an ETF? An ETF trades like a stock but represents a basket of stocks (for our purposes). You can have ETFs for lots of things, but we’ll keep it simple here and stick with stocks.
Now, let’s dig in to understand ETFs. ETFs often represent dozens, if not hundreds, or thousands of stocks. For example, the very popular ETF, VTI (Vanguard Total Stock Market), holds around 1,200 stocks in it. IWM follows the Russell 2000 index and contains over 1,900 stocks in it! At the time of this writing, you can purchase a single share of either for under $160. That is instant diversification!
What is a fund?
In the investment world, a fund, such as a mutual fund, is a way of pooling a bunch of investors money together to purchase securities. Now, mutual funds have their pros and cons. They are managed by a professional manager who makes buy and sell decisions on behalf of the fund. They also tend to be very fee heavy.
Mutual funds only execute trades once per day at the end of trading. So, let’s say you’re heavily invested in a tech sector mutual fund, tech is red across the board, and you’re getting nervous — tough luck. Luckily you had stop-loss orders, right? Nope. Mutual funds don’t have short sales, limit orders, or stop-loss orders.
Those are all features ETFs and stocks have, and that’s why ETFs are so attractive and popular. Instead of putting a bunch of money into a mutual fund, and owning fractions of the stocks in the fund, you purchase ETF shares, which represent fractional ownership of their underlying stocks.
ETFs vs. Individual Stocks
ETF fandom aside, let’s get to the real reason you’re here. Which is better, ETFs, or individual stocks?
It depends on what you value.
ETF Pros
ETFs can be excellent in that they offer diversification without a significant investment.
Think about it:
If you buy an ETF that represents 20 different stocks, you can get a portion of a share for each company for one low price. If you were to purchase each stock, it could become very costly.
Additionally, you can easily purchase ETFs in different sectors and have a massively diversified portfolio in no time. Imagine having to examine each stock before purchasing them. It would take a long time to assemble a quality portfolio.
One last thing I like about ETFs is that they offer a certain level of management. For example, I own a few ETFs that focus on dividends. When one company cuts its dividend or eliminates it, the ETF sells off the stock and replaces it with a new company. This is called portfolio turnover, and while it’s not ideal because portfolio turnover costs money, it is a low-maintenance way to invest.
If I owned all of these stocks, I would need to watch each of them for dividend cuts or eliminations, sell them, and replace them all on my own. Instead, these ETFs follow an index managed by a professional, or the ETF itself is managed by a professional. They do all of that work for me.
ETF Cons
Now, let’s talk about the cons of ETFs. ETFs aren’t free. They have expense ratios that cost money. Many ETFs have expense ratios of nearly 1.5% – 2%! I don’t invest in ETFs with ratios like that, but they are out there.
Let’s say you invest $10,000 in an ETF that has an expense ratio of 1.25%. That means, each year, that ETF costs you $125!
The other primary con of an ETF is that it might be exposed to a stock that you don’t like or trust.
Additionally, when you own an ETF, you don’t own the underlying shares themselves. This means that you don’t have voting rights. That’s not a significant issue for most investors, but it could give pause to people who are dropping large amounts of money and want their voices heard.
Individual Stock Pros
When it comes to individual stocks, the only limits are your time, imagination, and wallet! You can create a truly custom portfolio that fits you better than a diving suit! You can buy as much of your favorite company as you want. You can use any investment strategy you want. Goodness, you can even purchase great stocks when their price seems undervalued!
When it comes to customization, nothing beats individual stocks. Oh, and they also have the best fee of all: free! After purchasing your shares, that’s it, no more fees. While it’s a minor thing for most investors, you also maintain your voting rights in the company, assuming you purchase shares of stock with voting rights.
Individual Stock Cons
The only significant cons with individual stocks are the cost and time. You need a relatively substantial investment to diversify well. It also takes a lot of time to research individual stocks.
While you should study and understand the ETFs you invest in, the diversification shields you from bad companies in the ETF. With individual stocks, you’ll likely end up more concentrated in fewer companies simply because you have to buy whole shares. When you’re more concentrated, it amplifies your good and bad purchases when compared to diversified investments.
Who Wins? ETFs or Individual Stocks?
In my opinion, the clear winner for most people is the ETFs. You get diversification, liquidity, and more hands-free investment. The few cons can be controlled pretty well. When it comes to costs, choose ETFs with low expense ratios.
For some people, stocks are the winner, but that comes down to fee sensitivity and your feelings about ownership. There is a fair amount of controversy around ETFs because you don’t truly own the stocks in the ETF. If that bothers you, then ETFs are not the right choice for you.
Few people will argue the versatility and benefits of ETFs, but many still prefer individual stocks over ETFs. It’s a very personal decision with no correct answer. You need to choose what fits your style, comfort, and situation best.