As exchange-traded funds (ETFs) have grown in popularity, more and more people are considering them as a fundamental part of their investment portfolio. Imagine that you want to invest in a particular sector or geography – would it be better to invest in an individual stock or an ETF?
There are similarities and differences when comparing stocks and ETFs, but they serve different purposes and the right decision for you will depend on your circumstances and what you’re trying to achieve by investing.
In this article, we’ll briefly establish what ETFs and stocks are, before taking a look at the differences and similarities between them.
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What is a stock?
An individual stock or equity is a share in a company. Investors can buy a stake in a company and the value of that stake rises and falls depending on the company’s performance and its valuation.
Stocks are bought and sold on exchanges and make up a large chunk of most investment portfolios. For the issuing corporation, selling stocks is a way of raising capital to operate the business.
What is an ETF?
The simplest way of thinking about an ETF is as a basket of stocks. Rather than having a stake in one individual company, an ETF can contain hundreds or even thousands of individual stocks. They are usually made to track a particular index, to reflect the performance of the S&P 500 or the FTSE 100, for example.
ETFs aren’t issued by individual corporations. Instead, they’re largely sold by financial firms like brokerages. At a glance, ETFs are an easy way for investors to achieve diversification and avoid overreliance on the performance of individual companies.
Similarities between ETFs and individual stocks
The key similarity between ETFs and stocks when it comes to investing in them is that they are both sold on exchanges. This means they can be bought and sold quickly and are available for purchase whenever the stock market is open, meaning they are both traded throughout the day and have high liquidity.
Differences between stocks and ETFs
The key differences between ETFs and stocks are:
Diversification. Individual stocks are (relatively speaking) quite high risk investments. It’s difficult to predict the performance of an individual stock and if a company performs poorly, there’s a chance you’ll lose a significant portion of your investment.
With an ETF, the investment is (usually) spread over a diverse array of businesses, asset types and even geographies. This means that the value of the investment is less dependent on the performance of the individual companies that make it up. However, not all ETFs necessarily provide diversity; some highly focused ETFs will track a niche industry, for example.
The number of shares. When a company issues stocks, a fixed number is sold. This means that, generally speaking, the number of shares does not change often. There are occasions like stock buyback or stock split where the number can change, but these aren’t common.
With ETFs, the number of shares per ETF can change fairly regularly, to attempt to match the net asset value of the fund. Put simply, the ETF issuer can change the number of shares in the fund to raise or lower its value.
Risk. Generally, ETFs tend to be less volatile assets than stocks. Because the performance is dependent on a number of different companies and assets, the idea is that any underperformance from one company can be balanced by good performance elsewhere. It’s unlikely, then, that ETFs will see wild swings in either direction.
This stability relative to individual stocks (which can fluctuate dramatically) is a large part of the appeal of ETFs for long-term investors. It should be noted, however, that there are some ETFs – those that track volatile industries like oil and gas – that are just as risky as individual stocks. It’s important to do your research when selecting ETFs.
Both ETFs and stocks are great investment vehicles that have high liquidity and a low barrier to entry for investors. A stock entitles the holder to a share of the company’s profits, where an ETF gives the holder a stake in a much larger collection of stocks. Both are traded daily, both give dividends and both can be an integral part of a long-term investment strategy.
Where some investors are drawn to stocks for their potential to provide high returns (there is also the risk of losses), ETFs have grown in popularity thanks to their long-term outlook and relative stability. So, when it comes to comparing ETFs and individual stocks, it depends on what you’re trying to achieve and how long-term your approach to investing is.
When investing, your capital is at risk.