Stocks vs. ETFs: Which Side Do You Choose?
The Risks, Rewards, and Tax Advantages of ETFs and Stocks
We talk a lot about exchange-traded funds (ETFs) and mutual funds, and we’ve even discussed ETFs versus indexes, but how do ETFs stand up against individual stocks? Let’s line them up against each other in various categories to determine which comes out on top.
The Big Picture
Exchange traded funds have a certain yawn-worthy reputation in some circles. They're not always very exciting. Returns tend to be in the average range.
But that typically makes them safe...or safer than many stocks anyway. Stocks can and often do exhibit more volatility.
Apples and oranges are both fruits with their own unique allures and they appeal to different tastes. The same applies to stocks and ETFs. Your personal tolerance for risk can a big factor in deciding which might be the better fit for you, as can your other unique personality quirks. Measure your preferences against these factors to get a better idea of which way you want to lean.
And remember, this comparison assumes that you're putting together a portfolio of all ETFs or all stocks when everyone knows diversity is king. If you still find yourself on the fence, consider an investment blend. That might be the safest option of all—assuming safety is your paramount concern.
Ease of Transaction
- Stocks: With some exceptions, stocks are pretty easy to buy and sell. You can call your broker or sign into your online account and make the trade. You're done, just like that.
- ETFs: Exchange traded funds are just as easy to buy, but unlike an index, it’s just one transaction.
This one is a tie as far as which is preferable when you're considering entering the stock market or ETF market. Is your time valuable down to the nanosecond? If so, ETFs might have a slight edge.
- Stocks: Your commissions are based on each trade.
- ETFS: Your commissions are based on each trade.
You see where this one is going. The transaction costs of ETFs are less than indexes and mutual funds, but it's a wash when you compare them to those of stocks. Costs are per trade of the asset with both stocks and ETFs. This one really is a tie. No winner.
- Stocks: Some are very liquid and others are not.
- ETFs: Again, ETFs straddle the board, but fewer ETFs are liquid.
A general edge has to be given to stocks in this category if you prefer liquidity.
Risk and Reward
- Stocks: Individual stocks can have different risk betas.
- ETFs: An ETF is slightly less risky because it’s a mini-portfolio and therefore it's somewhat diversified, but it really depends on what's in the actual ETF.
Remember, with less risk comes less chance of reward. It all comes down to your risk tolerance. We have to call this one a tie since it’s case-by-case for each such investment.
- Stocks: If you're an active trader of multiple stocks, you might make the argument that an ETF carrying those same stocks gives you a tax benefit.
- ETFs: One of the tax advantages of ETFs is that they're treated like stock transactions on your tax return, unlike mutual funds and indexes.
Because both ETFs and stocks are single transactions, capital gain taxes can be incurred when the fund or equity is sold. The advantage goes to ETFs in this battle.
- Stocks: Both ETFs and stocks list options, but there are more calls and puts on equities than ETFs.
- ETFs: Exchange traded funds tend to be more limited than stocks on a sheer volume basis.
Options traders are always looking at how they can use derivatives in their trading strategies, especially for hedging purposes, so stocks have the advantage in this case.
Access to a Sector or Market
- Stocks: If you want to gain access to an industry, one stock purchase is probably not the best way to go. Buying multiple stocks is a more sound strategy. But which stocks do you buy? How many? Should you just buy an index basket?
- ETFs: You can simply buy a pre-packaged asset that gives you instant access to a sector, say like an industry ETF.
If your goal—or, more realistically, one of your goals—is to gain access to a certain market or sector, the advantage goes to ETFs.
- Stocks: You can create revenue streams for your portfolio with dividend stocks, although not for bonds because they are a different asset.
- ETFs: With bond funds and dividend ETFs, you can create revenue streams for your portfolio.
ETFs get a 2-1 win in this case. Advantage: ETF.
And the Winner Is…
So which asset is better? It depends.
Every investment choice should be made on a case-by-case basis, but the whole point of ETFs is to give investors mini-portfolios that trade like stocks. There are a lot of similarities between exchange-traded funds and equities for this reason—more so than when you compare ETFs to indexes or mutual funds.
Keep in mind, too, that the above comparisons are based on an individual stock versus ETF. The whole game can change if you're considering a custom portfolio of stocks versus an ETF. Commissions are different, tax implications change, and almost every comparison is impacted. But that's a discussion for a different day.