Stocks vs. ETFs: Which is right for you?
Understanding the similarities and differences between stocks and exchange-traded funds (ETFs) is the first step in deciding how they may fit your investment goals. But first, let’s be clear about what stocks and ETFs are:
You probably already know that a stock represents a fraction, or share, of ownership in a specific company. An ETF, on the other hand, is a collection, or "basket", of individual stocks, bonds, or other investments, all pooled together. When you buy a share of an ETF, you own a fraction of that pool of investments.
How are they similar
Both stocks and ETFs...
- Trade on an exchange, offering high liquidity and transparency. Because stocks and ETFs are traded in high volumes throughout the day on an exchange, it’s typically easy to buy or sell shares at will. The exchanges also show real-time or near real-time bid/ask price quotes and volumes of shares being traded, letting all investors see key trading information. This is known as price transparency, and other investments such as mutual funds or real estate may not be as transparent.
- Give you a broad range of investment options. They both can be used to invest in many different industries, in companies of different sizes, in markets around the world, and more.
- Support a wide variety of order types. With market, limit, good for day, good until…, and other order types, investors have a range of choices about how they acquire shares and what price they pay for them.
- Make it possible to use options or even sell short. Options are available for many stocks and ETFs. And if you want to try to profit from falling prices—a practice known as short-selling or “going short”—there are established ways to do it with both types of investments.
- May pay dividends Many companies periodically pay dividends—a portion of the firm’s profits—to shareholders. Similarly, ETFs may receive dividends from stocks they hold, which are in turn paid through to investors who own shares in the ETF.
- Can be traded with zero commissions at E*TRADE.1
How are they different
|Risk vs. potential return||An individual stock is a high risk investment, with potentially wide price swings and the possibility of large losses if things go badly for the company. But a stock may also provide bigger gains if you pick the right company.||Because ETFs invest in dozens or even hundreds of companies, most have significant built-in diversification. This means that one poor performing stock can potentially be offset by other, better performing stocks within the fund. But this may also tend to limit potential gains.2|
|We can see how this works in an example: Over one recent five-year period, one stock in the S&P 500® index gained about 400% while others in the same index lost 40% or more . You’d have big success if you picked the right stock, and big losses if you picked the wrong one.
Over that same period, the ETF designed to mimic the returns of the whole S&P 500, gained about 200%. So it didn't do as well as one of the best performing stocks in the index, but it did much better than the worst performers.
|Cost to diversify||To get meaningful diversification with stocks, you have to separately buy shares in many different companies.||A single share of an ETF is inherently a mix of many different investments. So you can typically use ETFs to achieve diversification with much less invested money than you’d need in order to buy the same stocks individually.|
|Market exposure||Stocks make it easy to focus some of your investment dollars on a specific company that you believe in—one that is unusually well-managed or innovative, for example.||The many different types of ETFs offer investors simple ways to get broad exposure to different markets. Many ETFs are designed to track the results of indexes such as the S&P 500, for example. Others focus on business sectors such as technology or energy. Some follow specific strategies such as “growth” or “value” investing. Unlike stocks, however, you can't use an ETF to focus on a single firm.|
|Research and legwork||If you're a stock investor, you have to do all the research and trading yourself. Some investors welcome this, but others may find it too time-consuming or difficult.||ETFs are professionally managed, based on the goals outlined in the fund's prospectus. All the work of researching, buying, and selling individual stocks is done for you. ETFs charge investors a fee called an expense ratio for these services. Of course, you must decide which ETFs to buy, so there is still some research required.|
|Control over investments||If you're a stock investor, you make decisions about exactly where your money goes, and which companies to invest in. Some investors welcome this direct control; others may find it too time-consuming or difficult.||ETFs are professionally managed, based on the goals outlined in the fund's prospectus. The managers do the work of researching, buying, and selling individual stocks.|
|Types of securities||A stock is one particular type of security, or investment instrument, but there are other important securities such as bonds (a type of loan).||Many ETFs invest in stocks, but you can also buy ETFs that invest in bonds, a mix of stocks and bonds, currencies, commodities, and more. These other securities can provide another form of diversification.|
Note: Short selling can only be effected in a margin account
Which is right for you?
Stocks can potentially give a better return for investors who are comfortable taking on more risk. And buying individual stocks allows you to make a focused investment in a company or business which you really believe in.
In contrast, most ETFs may help reduce risk and give investors a way to diversify with less money as well as gain exposure to sectors, regions, and broader markets more easily.
And remember, nobody says you have to choose one instead of the other. For many investors, a portfolio that contains stocks, ETFs, and other securities may be the foundation of a diversified overall investing strategy.
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