Becoming a confident investor starts with having foundational knowledge about how the market works and what your investment options are. Even if you are working closely with a financial advisor, it’s always in your best interest to be acquainted with the ways in which your wealth is being managed.
Getting familiar with common investment vehicles is an important step. While you probably have a general idea of what a stock is, you may not be aware of what an ETF is or the difference between individual stocks and ETFs, so let’s take a look.
What is a Stock?
When a corporation’s ownership is divided into portions, it means there is shared ownership of the company. The portions, or shares, are known as stock, and with publicly-held companies, this is what’s traded on stock exchanges like the New York Stock Exchange (NYSE) or the Nasdaq. By buying a stock, you are buying a portion of the company, and when you own a stock, you are an individual shareholder, laying claim to a portion of the company’s assets and earnings.
Companies issue shares to raise capital, which enables them to fund business operations. So when you buy stock in a company, you’re putting up your money to fund the business in exchange for a portion of a claim on future company earnings. In other words, you’re betting on the company’s executives to be able to create gains that will allow you to sell your shares at some point down the line—short or long-term—to recoup your investment and get a return.
What is an ETF?
ETF is short for exchange-traded fund. Like a stock, an ETF also trades on the stock exchange, but it doesn’t represent an individual share in a company. It’s a pooled investment fund, professionally managed, similar to a mutual fund, that purchases a diverse range of assets— stocks, commodities, bonds, and other securities—and places them into what’s referred to as a basket. For example, the ETF could represent a commodity, such as gold or oil, track a particular sector or index, like the S&P 500 or the Dow Jones Industrial Average, or include stocks and bonds that meet given criteria.
With an ETF, instead of buying shares in a company, as an investor, you would buy shares of the fund and the fund itself holds the underlying assets. But ETFs differ from mutual funds because you don’t have to buy it directly from the mutual fund company or use a full-service broker. In essence, an ETF trades and distributes dividends like a stock, but it is an investment vehicle that allows you to diversify your investments.
What are the Pros and Cons of an ETF vs. a Stock?
Understanding the benefits and drawbacks of investing in an ETF versus buying individual stocks can get complex, but it is important to know what the potential benefits are and what limitations can come into play.
Pros of investing in ETFs
The most obvious benefit of investing in ETFs is that the fund inherently brings more diversification to your portfolio than buying individual stock. By diversifying, you are spreading your risk, minimizing the impact of market volatility, and more easily obtaining an optimal allocation aligned with your financial goals.
Additionally, an ETF allows you to tap into the investment strategy of the fund. Rather than selecting individual stocks based on time-consuming research, you’re trading on investment strategies that you may not be able to do on your own with individual investments. And if you have a goal to gain access to a certain market or sector, an ETF can help you do that in a pre-packaged manner.
Exchange-traded funds are also flexible vehicles. They can create income streams with their basket of holdings, with stocks that pay dividends or bonds. They can also be leveraged with margin and utilize option and shorting strategies, which are advanced high-risk, high-reward techniques, but again, some of that risk may be mitigated through the fund’s overall strategy. While you may not be ready for this level of investment, you should know these possibilities exist.
Finally, ETFs can help with your tax planning strategy. If you repurchase the same stock within 30 days of a stock loss, but you redeploy your loss proceeds into an ETF in the same sector, you can offset capital gains with capital losses. Again, this is an advanced strategy but something to be taken into consideration.
Cons of investing in ETFs
With all of the advantages that come with investing in ETFs, many investors consider ETFs to be boring because while the risk tends to be lower than investing in stock, the returns tend to be average. Safer investments are less exciting for investors who are comfortable with being more aggressive because with less risk comes less chance of reward. Your personal tolerance for risk can help you decide what types of investments are the best fit for you.
Another limitation is that you’re giving up some control when you invest in ETFs versus stocks. Before buying individual stocks, you have the ability to research the company, look into their business operations, and read up on their earnings history and projections for upcoming quarters. With ETFs, you’re trusting the fund manager to make investment decisions on that level for you.
Giving up some control in your investment choices also means you’re putting faith in certain sectors and indexes. Whereas an individual stock might be performing well, a handful of stocks could be underperforming. So if you have a knack for picking undervalued stocks, you could miss your chance to cash in on the market price catching up to a stock’s growth potential.
Finally, the cost of owning ETFs is usually more than owning individual stocks. Whereas with buying stocks you would typically pay a one-time commission, you would pay a commission plus management fees and expenses when you own ETFs. The management fees are not usually as high as mutual fund fees, but it is something to consider when looking at your overall return on investment.
Now that you know more about exchange-traded funds, how they differ from stocks, and the advantages and disadvantages of using this investment vehicle, you have a better idea of whether or not this is something you will want to consider adding to your investment portfolio.
Contact your financial advisor to discuss the best possible investments for your risk tolerance and financial goals.
Kevin Stoddard is a LPL Financial Advisor with Stoddard Financial in Quincy, Massachusetts. Stoddard helps clients throughout New England to identify, plan, and execute strategies designed for securing their desired financial future. With their Financial Wellness @ Work program, they engage, educate, and empower employees by helping them to understand and appreciate the value of their benefits package.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
No strategy assures success or protects against loss. All investing involves risk including loss of principal.
Stock investing involves risk including loss of principal.
You should always consult your tax/legal advisor regarding your own specific tax/legal situation.
This material was prepared by Crystal Marketing Solutions, LLC, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate and is intended merely for educational purposes, not as advice.