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Foundational Trading Knowledge / Understanding the Stock Market 32 / 32
ETF vs Stocks: How to Choose the Best Investment

ETF vs Stocks: How to Choose the Best Investment

2020-05-28 10:41:38
Warren Venketas, Markets Writer
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The question of “are ETFs better than stocks?” is regularly brought up because every trader has certain investment requirements. This makes it essential to understand the distinction between trading ETFs vs stocks in order to make informed trading decisions.

This article will outline the following:

  • How to choose between Exchange Traded Funds (ETFs) or stocks
  • Eight key differences between ETFs and Stocks
  • ETF vs Stocks: Frequently asked questions (FAQs)

How to choose between ETFs or stocks

Choosing between ETFs and stocks is not always straight forward as each brings its own traits to the investment decision. There are certain aspects that need to be considered. Below are a list of important factors to give attention to:

1. Goals

The first step in selecting an ETF or stock is to factor in investing objectives. What this means is that each trader will have certain exposure requirements regarding the trade. This relates to either a specific type of stock or a broader sector such as financial services or construction that may be represented by an ETF.

2. Risk appetite

Risk is an essential factor to consider before investing in any financial instrument. Investors will need to decide on how much risk to take on which should correlate to their current financial status and goals. Over-exposing oneself to excessive risk is not recommended and investors should stay within their financial means. It is often accepted that younger individuals are generally more risk-seeking whilst older investors tend to be more risk-averse, and considering timelines until retirement at which point nest eggs may need to be drawn from, that investment approach may make sense for many portfolios of investors getting more conservative with age.

3. Investment timescale

The length of the investment will vary depending on the investor’s requirements/goals and this can affect the investment decision between ETFs or stocks.

4. Investment budget

Each individual investor will have different investment budgets at their disposal. Ensuring that this budget is adhered to and not stretched is crucial to responsible investing.

Investing in ETFs or Stocks: A practical example

“I am an investor looking for long-term growth exposed to the technology sector with a high-risk tolerance and $1000 to invest.”

In this case, the investor may be more inclined to invest in an Exchange Traded Fund as opposed to various individual technology stocks as it would be cheaper to trade one product that gives the similar/same exposure to the desired market.

Because no individual technology company is a guaranteed success, it can be beneficial to invest in a broad spectrum of technology stocks to compensate for any companies that fail long-term. The budget constraint in this case further supports ETF investment as multiple purchases of several stocks will deplete the investment budget more so than a single ETF purchase.

Selecting an ETF or stock can be tricky but, once an investor is aware of the differences between ETFs and stocks, they will be able to make informed investment decisions.

Top 8 differences between ETFs and Stocks

ETFsStocks
1. DiversificationYesNo
2. LiquidityLowerHigher
3. Price riskLowerHigher
4. Potential RewardLowerHigher
5. Sector AccessHigherLower
6. TaxLocation dependantLocation dependant
7. Control of investmentLowerHigher
8. CostHigherLower

1. Diversification

ETFs provide greater diversification as opposed to individual stock investing. This is one of the most attractive features of ETFs as it includes a variety of stocks under one instrument. Some traders prefer to isolate their exposure to one stock which then moves away from ETF trading and toward single stock trading.

2. Liquidity

Liquidity refers to the ease at which assets can be converted to cash. Generally stock liquidity is seen as higher than that of ETFs as the volume of one company is easier to determine than that of multiple stocks within an ETF. However, there are some stocks that are less liquid than certain ETFs. Liquidity rarely presents issues for the average investor but may arise for large buyers or sellers.

3. Risk

Because of diversification, ETFs have the risk spread out throughout the different stock constituents. This is not true for all ETFs as certain commodity tracking ETFs can have similar risks as a single stock.

4. Potential Reward

Generally, stocks are seen to carry greater potential reward as returns are not diluted by diversification. This being said, potential loss would also carry the same weight. It is important to keep in mind that less risk usually carries less reward and vice versa. This then ties in with trader goals and risk appetite as mentioned above.

5. Sector Access

Sector access ties in with diversification whereby investors can gain access to a broad sector of stocks under one investment vehicle. ETFs have grown exponentially since inception which saw the introduction of sub-sector ETFs for even more specificity.

6. Tax

Tax can be tricky to differentiate for ETFs and stocks as these are dependent on the applicable jurisdiction. Investors will need to clarify tax implications before investing to avoid potentially exorbitant tax costs.

7. Control of investment

Investing in stocks gives the investor 100% control of what is being invested in and precisely how much is allocated to each stock. ETFs may outline initial weightings of the fund but this can change based on share price fluctuations or economic outlook.

8. Cost

ETFs often come with increased cost due to management fees associated with the fund. Stocks and ETFs usually have a commission charge attached to each purchase and sale. This makes stock investing cheaper in a general sense given the inclusion of ‘expense ratios’ with ETFs. With numerous brokers to choose from the cost aspect of ETFs vs stocks will vary due to the increased competition amongst brokers.

Should you invest in ETFs or Stocks?

The choice between investing in ETFs and stocks should be made with the investor’s goals and risk appetite in mind. What may work for one investor may not be the same for another. Knowing the difference between ETFs and stocks will guide traders to the most appropriate conclusion. Through research is important however, selecting a suitable broker is equally critical.

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ETF vs Stocks: Frequently asked questions (FAQs)

Are ETFs comprised of stocks only?

Exchange Traded Funds are not isolated to solely stock components. There are ETFs that include bonds, commodities and even foreign currencies or forex. Other ETFs are comprised of a combination of different financial instruments so knowing exactly what is included in a prospective ETF is crucial to align investment goals for the most fitting decisions.

Which is the best ETF to buy?

As we know the ETF market is a dynamic environment that offers a wide range of products. Within every ETF sector there are top performers which vary with performance of the underlying components of the ETF.

When selecting an ETF to buy, it is prudent to consider the full picture rather than just the historical performance of the ETF. Guiding decisions based upon past performance can be dangerous because there are no assurances that the past performance will continue in the future; and little is certain in financial markets therefore the best ETF to buy will be one that suits the investors trading goals, risk, time horizon and budget.

Further reading on ETFs and stock trading

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