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Most investors typically have the same goal, to reach alpha. Alpha is an investment term used to describe a strategy that is outperforming the market and resulting in excess returns.
In other words, people invest to see their money grow and to generate wealth. There are several investing tools and strategies to consider if you’re looking to make an active return and one of the most common options is ETFs.
ETFs are exchange-traded funds and they are similar to stocks but also have some key differences. Let’s have a breif look at what ETFs and stocks are, and dive into their key differences and how these two options impact your investment strategy.
What is an ETF?
An ETF, short for exchange-traded fund, represents a unique investment vehicle with distinct characteristics. ETFs are traded on stock markets and allow investors to acquire shares through taxable brokerage accounts or retirement funds. These investment options have gained popularity among novice investors due to their abundant availability.
In essence, an ETF can be likened to a well-diversified assortment of investments. For instance, an ETF may constitute of a blend of high-value stocks, municipal bonds, and exposure to precious metals. By purchasing shares of an ETF, investors obtain fractional ownership of the underlying investments, based on the specific composition of the fund.
The process of purchasing ETFs is relatively straightforward. They can be acquired in a manner akin to buying stocks, with a wide array of choices at hand.
What is a stock?
A stock is a form of ownership in a publicly-traded company, providing investors with rights and benefits such as dividends and voting privileges.
The nature and investment potential of stocks lie on their various characteristics, including ownership, dividends, risks and returns, classes, their market cap, sector and industry.
In addition, stocks can exhibit different levels of price volatility (some having significant price swings compared to others) and liquidity (some can be easily bought or sold compared to others).
Within the stocks' two most common categories - common stocks and preferred stocks, many other types exist.
Key differences between stocks and ETFs
Stocks represent a piece of ownership in a publicly traded company. ETFs are a bundle of assets and securities such as different stocks and bonds. A single ETF can contain dozens or hundreds of different stocks, or bonds or almost anything else considered an investable asset.
Since ETFs are more diversified, they tend to have a lower risk level than stocks. Similar to stocks, ETFs can be bought and traded at any time and they are also taxed at short-term or long-term capital gains rates.
The assets inside an ETFs are bought and pooled together by the fund’s managers. Shares of the fund itself are then an ETF bought and sold by investors on a stock market, like the New York Stock Exchange.
Group of securities including stocks and bonds.
Individual shares of a company.
Risk is more diversified than a single stock, but not without risk.
Risk depends on the fortunes of the company.
Can be more illiquid (depending on the fund).
The pros and cons of stocks
- Returns can be higher than ETFs: Even though stocks are generally a riskier investment, the returns can be greater, especially if the company is growing quickly.
- Commission-free trading options: There are many commission-free options that allow you to trade stocks without spending an extra penny.
- You’re not paying someone to manage your stocks because you are the manager.
- Riskier investment: Investing in stocks is seen as a riskier investment than in a diversified fund because your capital is tied to the fortunes of a single company. With ETFs, especially indexed ETFs that contain tens or hundred of companies’ stocks, there is more diversity to help mitigate your risk.
- More effort: Picking winning stocks requires more effort in research and paying attention to continuing performance.
The pros and cons of ETFs
- More diversified: With ETFs, you can buy one fund and gain access to stocks for several companies.
- Reduced risk: Since you’re investing in a variety of assets, ETFs can reduce your risk since you aren’t putting your eggs in one basket.
- As convenient as trading stocks: Buying shares of ETFs is as easy as buying shares of stock, and you can do it from your taxable brokerage account or a retirement account.
- Less control over what you’re investing in: Since ETFs are pre-selected investment funds, you can’t pick and choose which specific stocks or bonds you’re investing in.
- May underperform stock investments: Even in a good year, an ETF based on a basket of stocks can underperform a single stock investment that is outperforming the market.
- Management fees: Even index ETFs have management fees, and actively traded ETFs’ management fees can be quite high. The management fee takes money out of your total return.
When picking stocks might work
Following stocks and analyzing the market takes a lot of time and effort. You’ll want to stay on top of market news, company updates, and really expand your knowledge on picking stocks in general. Famous stock investors like Warren Buffett usually give similar advice: buy shares of companies with a great business model, solid earnings and excellent management.
It’s impossible to tell the future or guarantee how certain stocks will perform. However, you can find some companies you feel comfortable investing in that have proven to be successful historically. This hands-on strategy could outperform the returns from ETFs if you’re able to be dedicated to it.
When an exchange-traded fund (ETF) might be the Best choice
Investing in ETFs is the better choice if you want to diversify your holdings to reduce risk. Perhaps you’re not interested in poring through company quarterly reports and investing newsletters and would rather have someone else pick and manage your holdings.
ETFs still perform well and can even beat out stocks and hands-on investors with very little effort on your part. You should still be willing to research different ETF options, but you don’t have to be so concerned about picking “winners” as such.
With either stocks or ETFs, you do want to get advice from a financial advisor to help you not only pick investments but also manage your tax exposure and your long-term strategy and goals. WiserAdvisor can point you to a qualified professional to guide you.
Stocks and ETFs aren’t either/or, they’re both/and
When it comes to stocks vs. ETFs, one is not better than the other. They are both solid ways to invest your money depending on your interest and goals. In fact, you can do both to further diversify your portfolio.
Knowing how both stocks and ETFs work as well as the core differences between the two can help you make a wise decision for your strategy.
Frequently asked questions (FAQs)
Are ETFs good for beginners?
ETFs are a solid option for beginners due to their low expense ratio and diversity. ETFs are also a more liquid investment and have a very low investment threshold.
Do I need to pay taxes on ETFs?
Yes, when you sell shares of an ETF for profit, you’ll owe taxes on the “realized gain.” A realized gain is a return on an investment that indicates it was sold at a higher price than what it was originally paid for. You may also have to pay taxes on income from an ETF if it pays a dividend.
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