Stocks vs. ETFs: Which Side Do You Choose?
The Risks, Rewards, and Tax Advantages of ETFs and Stocks
In the world of investing there are many products like stocks, exchange-traded funds (ETFs), mutual funds, and bonds for you to choose from as you build your portfolio. Of course, you want your investment to perform well, return profits, or grow—depending on your goals and investment risk tolerances. Each investment product brings its own unique set of benefits and disadvantages. With so many different choices, many investors find it hard to decide what exactly to invest their funds into—especially when it comes to choosing between stocks and ETFs.
Stocks vs. ETFs
Let's start with a brief definition of what a stock is and what an ETF is. You will hear both stocks and ETFs called assets and securities. Don't let these different terms confuse you. They are just general terminology and can also refer to other investment products—like mutual funds and bonds—as well.
Stocks—also known as equities—are shares of publically traded companies. A share of stock is like owning a small portion of a company. A business will sell stock to raise funds for various reasons. Some stocks allow owners to vote during shareholder meetings and may pay a portion of the company profits to the investor—called dividends. Stocks primarily trade on stock exchanges like the New York Stock Exchange (NYSE) or the Nasdaq.
The value of a stock share will change depending on the company, the economy, and many other factors. Most stocks are common shares and allow holders to vote during meetings. You will also see preferred shares with do not allow this option but may offer greater returns of company earnings to the holder. There are also penny stocks which are shares of small companies. Trading in penny stocks is risky and considered speculative.
Exchange-traded funds (ETFs) are a type of professionally managed, pooled investment. The ETF will buy stocks, commodities, bonds, and other securities and place them into a basket. They will then sell shares of the basket of holdings to investors. Managers will buy or sell portions of the basket holdings to keep the fund aligned to any stated investment goal. As an example, an ETF may follow a particular index or industry sector, buying only those assets to put into the basket. ETFs trade on exchanges just like stocks.
The value of an ETF share will move throughout the day based on the same factors as stocks. ETF will usually pay a portion of earnings to investors after deducting the expense for the professional management. You can find ETFs that focus on a single industry, a country, a currency, and bonds. Some are inverse—meaning they move in the opposite direction of the market.
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 depending on the economy, global situations, and the underlying company itself.
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. Risks can include your ability to see the investment taking wild swings in value, your horizon—or how long you have before you need to withdraw invested funds, and your earning capacity. Measure your preferences against these factors to get a better idea of which way you want to go. Investors can fall anywhere on a line between taking high risks and being aggressive to limiting all risk and being conservative.
Let's delve a little bit deeper and compare stocks and ETFs by some important measurements. 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.
Ease of Transaction
With some exceptions, stocks are pretty easy to buy and sell. You can call your broker or sign in to your online account and make the trade. You're done, just like that. Some stocks can be bought directly from the issuer. Penny stocks, for the most part, are harder to buy and even harder to sell.
ETFs trade only on exchanges. So, you will need a brokerage account of some type. However, once you have that, they are just as easy to buy as stock.
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.
Your broker will charge you commission or fees on every trade you make—both when you buy and when you sell. Fees will vary by broker and by how much money you have in your investment account. Both stocks and ETF transactions will incur fees.
So, you see where this one is going. This one really is a tie. No winner.
Liquidity Factors Stocks vs. ETFs
Liquidity refers to how easy it is to convert stock or ETF holdings into cash or another investment. With stocks, it will depend on the corporation underlying the shares. If they are a recognized, financially stable, high-quality stock—known as a blue-chip stock—you will have no problem trading shares. On the other hand, penny stocks may take weeks or days to trade—if you can at all.
ETFs are near as liquid as stocks, for the most part. Again, it will depend on the quality of the products the ETF carries in its basket. The fund's trading volume will also impact liquidity.
A general edge has to be given to stocks in this category if you prefer liquidity.
Risk and Reward
Individual stocks can have different volatility or risk—known as its beta. This will depend on the stock, the industry, the overall market, and the economy. As an example consider shares in Exxon (X) a blue-chip stock. Imagine the risk attached to holding shares if suddenly a new and inexpensive alternative to gasoline became available.
An ETF is slightly less risky because it’s a mini-portfolio—basket—of investments. So, it is somewhat diversified, but it really depends on what's in the actual ETF. Returning to our example, an oil and gas ETF would be nearly as risky as the individual stock. However, ETFs might overcome this by spreading their holdings out around the globe or holding natural gas as well as oil stocks.
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.
Tax Implications of Stocks and ETFs
Uncle Sam is going to get his share. The Internal Revenue Service (IRS) will assess taxes on the dividend income—company profits returned to investors—from both stocks and ETFs.
You will also pay capital gains tax if you made a profit when you sell a stock or ETF. Capital gains are any increase above what you paid for the security. You can deduct your losses—up to a point—which will help offset the total value that capital gains are calculated against.
You can't deduct any commissions or fees you paid to trade the investment. It, along with the taxes, are part of the expense that you must offset by dividend payment or the growth in share value on the marketplace.
ETFs do have some tax advantages over mutual funds, but that should not play into the equation here. However, since both ETFs and stocks are exposed to taxes this, again, is a tie.
Options are complex trading products that require experience when transacting and outside the scope of this discussion. Suffice it to say, that both ETFs and stocks list option contracts, but there are more calls and puts on equities than on ETFs.
Options traders are always looking at how they can use derivatives in their trading strategies, especially for hedging purposes. So, in this comparison, stocks have the advantage due to a greater volume of options trading.
Access to Sectors or Markets
If you want to gain access to an industry or a country, one stock purchase is probably not the best way to go. Buying multiple stocks is a more sound strategy. Of course, each trade drives up the commission costs.
ETFs, on the other hand, are frequently industry-focused or country-focused in their basket holdings. You can simply buy a pre-packaged asset that gives you instant access to a sector, say like an industry ETF. The manager will do all the underlying buying and selling to keep the basket balanced—but at a cost.
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.
Stock vs. ETF Income Streams
You can create a stream of income from your portfolio of stocks that pay a regular dividend. There are many companies who share the company profit with shareholders. Some even have been proven to increase their dividend year after year—known as aristocrats.
ETFs can also create income streams with their basket of holdings. Often a fund will invest a portion of its funds into bonds—corporate and government debt products. They will disperse the income received from these investments to shareholders after deducting expenses.
Also, remember, Uncle Sam is waiting with his hand out on the sidelines to reduce your stream of income.
Both stocks and bonds can offer an income stream to the investor. They may approach earning that income in different manners. However, cash is cash, so this is another tie.
And the Winner Is…
Every investment choice should be made on a case-by-case basis with an eye to the risk involved for the individual. What is right for one investor may not work for another. Keep these basic differences and similarities in mind as you research your investments.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.