Stocks vs EFTs
Introduction
Okay, so you have made the decision to invest. Great! Now, it is time to figure out what to invest in. Of course, most people instantly think of stocks but there are other entities to put your money into as well. Mutual funds, bonds, high-yield savings accounts are a couple options just to name a few. However, ETFs (exchange-traded funds) are something that is quite similar to stocks. So, what is the difference between individual stocks and ETFs? If you do not know the difference, then maybe you can learn something that will help you make better investing decisions for your financial future.
What are stocks?
Before you can understand how an ETF works, you’ll first need to know what stocks are. So, what are stocks? Simply put, stocks are a unit of ownership in a business, which represents an entitlement to the profits of that business. A company’s shares can be bought and sold on stock exchanges if it is publicly traded. These include companies like Disney, Nike, Apple, and Lululemon. However, Chick Fil A is a private owned company so you cannot easily buy a share of that business.
Once a person buys stocks, they are now considered a shareholder and can vote at shareholders meetings for the directors of the companies. The best part is that they can now receive a share of the company’s profits (also known as dividends). The dividends are calculated by multiplying the number of shares you own by the amount of the dividend paid. For example, if you own 1,000 shares of a company, and that company pays a dividend per share of $0.68, you would be paid $668. The key is to find out how much dividends per share the company pays annually.
You may have noticed, a company’s share price changes all the time. The current share price for Chipotle (as I am writing) is $1,560.12 but two hours ago, it was $1,575.57 and who knows where it will be next month! There are actually a couple of variables that affect a company’s share price. One is revenues and profits. Simply put, if a company does not make that much income, then they can’t really give a lot to their shareholders. Another reason is the changes in the level of dividends can affect a company’s share price. It’s sort of like the opposite of the first reason. Let’s say a business is making a lot of money, then they would be able to give more back to their investors through dividends and, in return, they will want to buy more shares. The increase in demand will cause the share price to rise. The management or leadership can affect a share price because if shareholders believe in the company’s leaders, then they are more likely to buy more shares.
What are ETFs?
So now that we have covered the basics of stocks, let’s jump over to the difference between stocks and ETFs. An exchange-traded fund is a basket of securities that trade on an exchange throughout the day, just like a stock. It’s like owning a bunch of stocks or investment types.
Typically, ETFs will track a specific index, sector, commodity, or other asset. ETF share prices also fluctuate like stocks because they are bought and sold. They can also contain all different types of investments like stocks, commodities or bonds, some can even offer international holdings. The very first ETF was launched 30 years ago called the SPDR (SPY) which tracks the S&P 500 Index and it is still being actively traded today. ETFs usually are more cost-effective and liquid compared to mutual funds. An ETF can own hundreds or even thousands of stocks across various industries, or it can be structured to be under one sector. Because of this, ETFs give investors an easy and efficient way to diversify their investment portfolio without the hassle of selecting a multitude of individual stocks.
ETFs can be categorized as passive or active. Passive ETFs try to mimic the performance of an index, whether it is diversified like the S&P 500 or a more specific trend. Most ETFs are usually passively managed funds. Actively managed ETFs do not usually focus on index securities but have portfolio managers about which securities should be added in a portfolio.
There are many different other types of ETF investments available. Here are a couple of examples:
Bond ETFs – These can include government, corporate, state and local bonds. They do not have a maturity date and are used to provide regular income to investors.
Industry/Sector ETFs – These are made up of multiple stocks in an industry. The goal is to track a single sector through diversification to provide insight on high performers and maybe find a new company that has growth potential.
Commodity ETFs – As you can probably guess by now, these are used to invest in commodities like crude oil or gold. Having shares in commodity ETFs is more cost-effective than a physical possession of the commodity because it does not involve insurance and storage costs.
Currency ETFs – Currency ETFs track the performance of various domestic and foreign currencies. They help keep track of the development of certain countries and can be used to diversify a portfolio against volatility for forex markets.
What is the difference between stocks and ETFs?
Now, we can finally get to the bread and butter of this whole operation. Let’s use this section to get into great detail about what the differences are between stocks and ETFs.
- What is it you specifically own?
Stocks represent shares within individual companies and therefore, you own part of that company. Meanwhile, ETFs offer shares of multiple companies within a bundle. In the same sense, you would own shares of various companies. However, along with stocks, bonds and other assets can be included in the ETF.
- Where does the invested money go?
When one invests in stocks, then the money goes to the company where they use it. But before that, the money goes to a seller or broker when they facilitate the trade and might get commission. The same goes for ETFs. But let’s say you buy an S&P 500 ETF. In this case, your money will go to all of the 500 companies.
- Who manages the investment?
An investment manager or broker can manage and give advice to clients about what to do with their investments. However, you can manage your own portfolio and it often saves you money rather than hiring someone. For ETFs, you will need a brokerage account to buy and sell securities and you can hire someone or self manage also.
- What are the risk levels?
The difference between stocks and ETFs on risk levels is that ETFs can provide more benefits of diversification, which means there is less risk and volatility. This makes it safer than individual stocks because they are riskier but can yield high returns.
- How are they traded?
Stocks are traded through a process where buyers and sellers place bids and offers. Once the bid and the ask are agreed upon, then a trade is made. ETFs (just like in the name ‘exchange-traded funds’ would suggest) are traded on exchanges. They can be traded throughout the day at prices that change based on supply and demand.
- How is commission paid?
If you have an investor who buys or sells your stock, then they might include a charge by the brokerage firms that makes the transaction. This would be considered a commission fee. The same is similar with an ETF. You will typically pay a commission every time you buy and sell an ETF. Unlike stocks, ETFs can charge expense ratios that are somewhere between 0.2-0.75% of your investment for various fees. For both sides, you might not always have to pay commission. However, if there is a commission-free ETF, then they might have higher expense ratio costs.
The pros and cons of individual stocks?
By now we should have a pretty clear understanding about the differences between individual stocks and ETFs. If you are still unsure about which to invest in, know that each option is going to have positives and negatives. Here are a few about individual stocks that will help you weigh your options:
Pros:
- Better chance at a short-term, higher reward
- Easy to get started
- More likely to outperform the market
Cons:
- Requires more risk
- Less chance of diversification
- Requires more time to manage your portfolio
- Emotional ups and downs
The pros and cons of ETFs?
On the contrary, some pros and cons of exchange-traded funds (ETFs) are as follows:
Pros:
- Access to stocks in different industries
- Controlled risks through diversification
- You can target a certain industry/index
Cons:
- Some actively managed ETFs have high fees
- Lack of liquidity if the ETF is traded at low volume and high volatility
- Less of a chance to outperform assets since they are more meant to track indexes, not beat them
Conclusion
Whatever you choose to invest in, whether individual stocks or ETFs, remember that risk will always be involved and to go for the long-term gains! If you need to get started, Invstr is the perfect app that will easily walk you through the steps and lessons you need in order to invest! Additionally, Invstr Jr is now available, so your kids can get in on the action as well.
Happy investing!
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