ETFs vs. Stocks Compared (Which is the better?)
This article examines the differences between ETFs and stocks.
The difference between owning ETFs and stocks is the same as the difference between owning a car dealership and owning a car.
A stock represents a piece of one company – like owning one car. ETFs hold a bunch of stocks, a bit like owning a car dealership that owns a lot of cars.
A single person can own a stock. With an ETF, groups of investors pool their money and managers of the ETF select the stocks the ETF will buy using everyone’s money.
The overall idea of using ETFs vs. stocks is that pooling funds allows everyone to spread their risk over lots of investments instead of just owning one.
Let’s have a deeper look at each and see what might be best for your situation.
What are stocks?
A stock is a tiny piece of ownership in a company. Suppose a company issues 1000 shares of stock and you buy 100 shares. You own 10% of the company.
Most companies issue hundreds of millions of shares, so individual investors rarely end up owning large percentages of a company.
The price of a stock that you own is going to rise or fall based upon the behavior of other shareholders, and their desire to own or sell their stock.
Time has demonstrated that the growth of a company’s earnings is the primary determination of what a given stock will trade for at a given time. The higher the earnings growth, the higher the stock price is likely to be.
What are ETFs?
ETFs are baskets of stocks. An ETF simply takes in the money of many investors, and than invests that money in a basket of stocks that may continually change or be re-balanced on a regular basis. The basket may have 30 stocks or it could have thousands.
The ETF offers exposure to large numbers of different stocks, which creates diversification, so that all of your eggs are not in one stock. While that one stock may rise and give you big rewards, but it may also fall and cause big losses.
With ETFs, it is highly unlikely all the stocks will rise or fall at the same time, which reduces overall risk.
What are the differences between ETFs and stocks?
When you own individual stocks, you decide on your own how you construct a portfolio. You select the stocks you want, you decide when to buy and sell each of them, and you choose how big or small you want your portfolio to be.
You, the investor, own a small percentage of a company that the stock you purchase represents.
With ETFs, you simply select a general investment strategy that appeals to you, but you must rely on the ETF manager to execute the strategy you desire, using his own expertise.
He chooses the stocks he thinks are best, and you not only have no input in what stocks he chooses, you have no right to complain if he blows it.
The other distinction is that, while you own pieces of many different companies, you technically only own a piece of a fund which in turn owns those pieces of companies.
Benefits of Investing In Stocks
When it comes to investing in ETFs vs. stocks, here are the advantages of stocks:
- You control the research you do.
- Individual stocks historically perform better over time
- You can invest in your own expertise
Here’s a video that gives additional information on investing in stocks.
You control the research
The biggest advantage in purchasing individual stocks, when it comes to investing in ETFs vs stocks, is that you control how much research you do on the company that its stock represents.
If you feel comfortable just knowing and understanding how a company makes money and generates cash flow, that’s your choice.
Alternatively, you can arrange to do such complete research that you will have an advantage over other investors who don’t do the research. Thus, you’ll have a better idea of when to buy and to sell.
You thus become the master of your own investments, and take all the credit if you invest in a great company that gives you a big reward.
Better performance over time
There is ample evidence that the performance of a successful company’s stock over time will exceed that of a basket of stocks over time.
There are two reasons for this.
First, a company’s stock price tends to rise as the same rate as its earnings growth. If a company starts out worth $50 million, then its stock becomes 1,000 times more valuable if the business becomes worth $50 billion.
So a company with great products and an entire world to conquer, that is constantly innovating, could provide great returns over time.
The second reason is that with a basket of stocks in an ETF, not every stock will be a winner or grow as much as a single stock might, and that tamps down returns over time.
Invest in your expertise
The famous mutual fund manager, Peter Lynch, advised investors to invest in things that they knowand understand.
If you work in a factory that sells widgets, you are going to understand a lot more about the widget business than anyone else. You should use that expertise to your advantage.
By using that expertise, you will know little details that matter in the big picture. It might be that you see more widgets being sold in your region during the summer than usual, and that is information regular people don’t have.
Benefits of Investing In ETFs
When it comes to investing in mutual funds vs. stocks, here are the advantages of mutual funds:
- Instant diversification
- Instant liquidity
Here’s a video that gives additional information on investing in ETFs.
The biggest pro when it comes to investing in ETFs vs stocks is that ETFs give you instant diversification. The ETF is a basket of different stocks, after all.
A properly managed ETF will also select a variety of stocks that gives it multiple forms of diversification. For example, it will select stocks from many different industries, that operate in many different geographies, that are based both in the US and in other countries, and that range in size from tiny to gigantic.
Just as you can buy or sell stocks at any time during the trading day when the market is open, you can alsobuy or sell ETFs in exactly the same manner.
Thus, you can change the entire structure of your portfolio with the press of a button.
Why would you want to do this?
Suppose you have a very large part of your portfolio invested in energy, using an ETF that invests in lots of different energy securities. Then there is news that oil supplies are very high and countries to sell oil are going to increase sales, driving oil prices much lower.
You can instantly reduce or sell out of an entirely diversified energy ETF in the blink of an eye.
Instead of having to slog through a time-consuming research process to evaluate a company, you can rely on the expertise of the ETF managers.
These managers tend to have lots of real world experience in evaluating companies, and can get in direct contact with management to ask questions, and see if a stock belongs in the ETF or not.
Alternatively, some ETFs are passive. Thus, instead of you constructing an entire portfolio of securities based on a popular set of criteria, many ETFs exist that have already constructed themselves to fit that criteria.