ETFs vs. Stocks: Which Should You Choose?
The Risks, Rewards, and Tax Advantages of ETFs and Stocks
If you are just beginning to invest, or have been for a while and are looking for other investment types, you have many different instruments to choose from. Stocks, exchange-traded funds (ETFs), mutual funds, commodities, currencies, bonds—and derivatives of each of these—are all available.
You want your investments to perform well, return profits, or grow—depending on your goals and investment risk tolerances. Each investment instrument 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 in—especially when it comes to choosing between stocks and ETFs.
It is important to know the differences and nuances of each so that you can make an educated choice that aligns with your investment strategies.
You will commonly hear both stocks and ETFs called assets and securities. While these terms might seem confusing, they really are not. An asset is anything of value you might own, and a security is an asset that you can trade, either in whole or in part.
Stocks—also known as equities—are shares of ownership issued by companies in efforts to raise funding. A share of stock gives you a portion of voting ownership in a company unless you purchase preferred shares (relinquishing voting rights brings higher priority in payment and often higher payments than common shares).
Shares of small companies are called penny stocks—trading in penny stocks is risky and considered speculative.
Common 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, their financial performance and structure, the economy, the industry they are in, and many other factors.
Exchange-traded funds (ETFs) are a type of professionally managed and pooled investment. The ETF managers will buy stocks, commodities, bonds, and other securities, creating what is generally referred to as a basket of funds. The funds within the basket are called holdings. Fund managers then sell shares of the holdings to investors.
While operating the fund, the managers will buy or sell portions of the holdings to keep the fund aligned with any stated investment goal. As an example, an ETF may follow a particular stock index or industry sector, buying only assets that are listed on the index to put into the fund.
Both ETF and stock values will change, or "move," throughout a trading day. These positions are traded by day traders—if you are a long term investor, these movements should not be concerning.
The value of an ETF share will change throughout the day based on the same factors as stocks. ETFs will usually pay a portion of earnings to investors after deducting the expense for professional management. You can find ETFs that focus on a single industry, a country, currency, bonds, or others.
There are even inverse funds available—which means the funds are designed to move in the opposite direction of the market with the intent of hedging the risk of their portfolio—hedging is the term used for purchasing investments that will reduce the risk of market shifts that might cause losses.
Inverse ETFs come with a significant amount of risk. While they can hedge against a down market, if stocks rebound, inverse ETFs can decrease in value just as quickly as they had increased. They're not meant for long-term investments, so investors should carefully consider whether it's worth the risk.
The Risks of ETFs and Stocks
Investments can be volatile; many factors affect investments—company executive turnover, supply problems, and changes in demand are only a few. Investments also come with inflation risk—a loss of value due to the decrease of value in the dollar. For instance, you might receive a $1.50 distribution from a stock issuer one year, and then watch the rate of inflation rise over the next year. The $1.50 you receive next year is able to purchase less than the previous year, making it less valuable.
Other risks are interest rate risk, which affects bonds—the risk of rates rising, which decreases the bond's price—and liquidity risk, or the risk of not being able to sell an investment if prices drop.
The volatility of a stock is measured using a metric called its beta. This is a comparative measurement, used to indicate the volatility of a stock based on the market it belongs to.
Risks can be measured and communicated using a stock's beta. A beta of 1.0 indicates its volatility is equal to the market, less than 1.0 indicates volatility less than that of the market, while greater than 1.0 indicates volatility higher than that of the market.
An ETF is slightly less risky because it’s a mini-portfolio—or basket—of investments. So, it is somewhat diversified, but it really depends on what's in the actual ETF. If you were to invest in an oil and gas ETF, you would assume nearly the same risk as purchasing an individual stock.
However, ETFs might overcome this by spreading their holdings out around the globe, holding natural gas as well as oil stocks, or diversifying the basket in other manners with a hedging strategy.
Liquidity Factors ETFs vs. Stocks
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 issuing 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 nearly 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.
Tax Implications of Stocks and ETFs
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.
Dividends are taxed as income unless they meet the criteria for qualified dividends, in which case they are taxed as capital gains.
You can't deduct any commissions or fees you paid to trade the investment. These expenses, along with taxes, are part of the costs you must offset with dividend payments or growth.
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 that share profits with shareholders. Some even have been proven to increase their dividend year after year—this is known as an dividend aristocrat.
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 instruments. They will disperse the income received from these investments to shareholders after deducting expenses.
The Big Picture
Exchange-traded funds come with risk just like stocks. While they tend to be seen as safer investments, some may still offer better than average gains, while others may not help investors see returns at all. It often depends on the sector or industry that the fund tracks and which stocks are in the fund.
Stocks can and often do exhibit more volatility depending on the economy, global situations, and the situation of the company that issued the stock.
ETFs and stocks are similar in that they both can be high-, moderate-, or low-risk based on the assets placed within the fund and the risk of those assets. Your personal tolerance for risk can be a big factor in deciding which might be the better fit for you. Both have fees and are taxed, and both provide income streams.
Every investment choice should be made based on the risk involved for the individual, their investment goals and strategies. What is right for one investor may not be for another. Keep these basic differences and similarities in mind as you research your investments.