Stock vs. ETF: Which Should You Buy? (2024)

Perhaps you've decided that you want to invest in a particular sector. Now you may be in the position of choosing between buying stocks or an exchange-traded fund(ETF).

Making this choice is no different from any other investment decision. As always, you want to look for ways to reduce your risk. And of course, you want to generate a return that beats the market.

Reducing the volatility of an investment is the general method of mitigating risk. Most investors give up some upside potential to prevent a potentially catastrophic loss. An investment that offers diversification across an industry group should reduce the portfolio'svolatility. This is one way that diversification through ETFs works in your favor.

Key Takeaways

  • When deciding between investing in individual stocks in an industry or buying an exchange-traded fund (ETF) that offers exposure to that industry, consider opportunities for how to best reduce your risk and generate a return that beats the market.
  • Stock-picking offers an advantage over exchange-traded funds (ETFs)when there is a wide dispersion of returns from the mean.
  • Exchange-traded funds (ETFs) offer advantages over stocks when the return from stocks in the sector has a narrow dispersion around the mean.
  • Exchange-traded funds (ETFs) may also be advantageous if you are unable to gain an advantage through knowledge of the company.

Achieving Alpha

Alpha is the ability of an investment to outperform its benchmark. Any time you can fashion a more stable alpha, you will be able to experience a higher return on your investment. There is a general belief that you must own stocks, rather than an ETF, to beat the market.

In addition, many investors are under the impression that if you buy an ETF, you are stuck with receiving the average return in the sector. Neither of these assumptions is necessarily true because it depends on the characteristics of the sector.Being in the right sector can lead to achieving alpha, as well.

When Stock Picking Might Work

Industries or situations where there is a wide dispersion of returns—or instances in which ratios and other forms of fundamental analysis could be used to spot mispricing—offer stock-pickers an opportunity to exceed expected returns.

Based on your research and experience, maybe you have a good insight into how well a company is performing. This insight gives you an advantage that you can use to lower your risk and achieve a better return. Good research can create value-added investment opportunities, rewarding the stock investor.

The Retail Industry Lends Itself to Stock Picking

The retail industry is one group in which stock picking might offer better opportunities than buying an ETF that covers the sector. Companies in the sector tend to have a wide dispersion of returns based on the particular products they carry. This may create an opportunity for the insightful stock picker to do well.

For example, let's say that you recently noticed that your daughter and her friends prefer a particular retailer. Upon further research, you find the company has upgraded its stores and hired new product management staff.

This led to therecent rollout of new products that have caught the eye of your daughter's age group. So far, the market has not noticed. This type of perspective (and your research) might give you an edge in picking the stock over buying a retail ETF.

Company insight through a legal or sociological perspective may provide investment opportunities that are not immediately captured in market prices. When such an environment is determined for a particular sector—and where there is much return dispersion—single-stock investments can provide a higher return than a diversified approach.

When an Exchange-Traded Fund (ETF) Might Be the Best Choice

Sectors thathave a narrow dispersion of returns from the mean do not offer stock pickers an advantage when trying to generate market-beating returns. The performance of all companies in these sectors tends to be similar.

For these sectors, the overall performance is fairly similar to the performance of any one stock. The utilities and consumer staples industries fall into this category. In this case, investors need to decide how much of their portfolio to allocate to the sector overall, rather than pick specific stocks.

Since the dispersion of returns from utilities and consumer staples tends to be narrow, picking a stock does not offer a sufficiently higher return for the risk that is inherent in owning individual securities. Since ETFs pass through the dividends that are paid by the stocks in the sector, investors receive that benefit as well.

Consider ETFs When Performance Drivers Are Unclear

Often, the stocks in a particular sector are subject to dispersed returns. However, investors are unable to select those securities that are likely to continue outperforming. Therefore, they cannot find a way to lower risk and enhance their potential returns by picking one or more stocks in the sector.

If the drivers of the performance of the company are more difficult to understand, you might consider the ETF. These companies may possess complicated technology or processes that cause them to underperform or do well. Perhapsperformance depends on the successful development and sale of new, unproven technology. The dispersion of returns is wide, and the odds of finding a winner can be quite low.

Industries Where ETFs Are a Better Option

The biotechnology industry is a good example, as many of these companies depend on the successful development and sale of a new drug. If the development of the new drug does not meet expectations in the series of trials (or the Food and Drug Administration (FDA) does not approve the drug application) the company faces a bleak future. On the other hand, if the FDA approves the drug, investors in the company can be highly rewarded.

Certain commodities and specialty technology groups, such as semiconductors, fit the category where ETFs may be the preferred alternative. For example, if you believe that now is a good time to invest in the mining sector, you may want to gain specific industry exposure.

However, let's say you are concerned that some stocks might encounter political problems that could hinder their production. In this case, it is wise to buy into the sector, rather than a specific stock, since it reduces your risk. You can still benefit from growth in the overall sector, especially if it outperforms the overall market.

In Jan. 2024, the SEC approved spot market Bitcoin exchange-traded funds for the first time. Trading cryptocurrencies may be easier through an ETF instead of the traditional routes, which include using crypto exchanges, the need for a storage wallet, and the need to keep private and public keys. ETFs in this case are especially useful for those unfamiliar with the crypto world but would like exposure to cryptocurrencies.

What Are the Downsides to ETFs?

Though ETFs make buying a swath of stocks easier, allowing for exposure to certain sectors, they do come with downsides. The downsides include fees associated with investing in ETFs, though these are usually fairly low. There is also the risk that the fund may veer away from the benchmark it is meant to track. Additionally, there is diversification risk within each ETF as they are concentrated in a sector. Furthermore, there is less control for an investor as they do not get to choose the specific stocks, and if an investor is looking to beat the index, that is not the goal of an ETF, so returns may be not as high as some investors desire.

Do ETFs Pay Dividends?

Yes, they do, for the stocks that pay dividends. So for a stock that does not pay a dividend, an ETF investor will not receive dividends from the ETF. If the stock pays dividends, the ETF must legally pass that on to the investor.

Do You Actually Own Shares in an ETF?

You do not own the underlying stocks/assets in the ETF, you only own shares of the ETF. For example, if you invest in an ETF and it buys shares of Apple, you do not own any Apple stock, you only own a portion of the ETF.

The Bottom Line

When deciding whether to pick stocks or select an ETF, look at the risk and the potential return that can be achieved. Stock-picking offers an advantage over ETFswhen there is a wide dispersion of returns from the mean. And with stock-picking, you have the ability to gain an advantage using your knowledge of the industry or the stock.

ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company,an ETF is your best choice.

Whether you are picking stocks or an ETF, you need to stay up to date on the sector or the stock in order to understand the underlying investment fundamentals. You do not want to see all of your good work go to waste as time passes. While it's important to do your research so you can be able to choose a stock or ETF, it's also important to research and select the broker that best suits you.

Stock vs. ETF: Which Should You Buy? (2024)

FAQs

Stock vs. ETF: Which Should You Buy? ›

ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.

Is it better to invest in stocks or ETF? ›

Advantages of investing in ETFs

ETFs tend to be less volatile than individual stocks, meaning your investment won't swing in value as much. The best ETFs have low expense ratios, the fund's cost as a percentage of your investment. The best may charge only a few dollars annually for every $10,000 invested.

What is the downside of ETFs? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

Should I invest in individual stocks or index funds? ›

Index funds often perform better than actively managed funds over the long-term. Index funds are less expensive than actively managed funds. Index funds typically carry less risk than individual stocks.

Should beginners buy ETFs? ›

Exchange-traded funds (ETFs) are ideal for beginning investors due to their many benefits, which include low expense ratios, instant diversification, and a multitude of investment choices. Unlike some mutual funds, they also tend to have low investing thresholds, so you don't have to be ultra-rich to get started.

Are ETFs more risky than stocks? ›

ETFs are less risky than individual stocks because they are diversified funds. Their investors also benefit from very low fees.

Why are ETFs less risky than stocks? ›

Diversification. One ETF can give investors exposure to many stocks from a particular industry, investment category, country, or a broad market index. ETFs can also provide exposure to asset classes other than equities, including bonds, currencies, and commodities. Portfolio diversification reduces an investor's risk.

Has an ETF ever gone to zero? ›

For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.

What happens when an ETF shuts down? ›

Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF. Receiving an ETF payout can be a taxable event.

Is it possible to lose money on ETF? ›

All investments have a risk rating ranging from low to high. An ETF with a low risk rating can still lose money. ETFs do not provide any guarantees of future performance. As with any investment, you might not get back the money you invested.

Why doesn't everyone just invest in the S&P 500? ›

That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market. But that's not necessarily a bad thing.

What is the best ETF to buy? ›

7 Best Long-Term ETFs to Buy and Hold
ETFAssets Under ManagementExpense Ratio
Invesco QQQ Trust (QQQ)$259 billion0.20%
Vanguard High Dividend Yield ETF (VYM)$55 billion0.06%
Vanguard Total International Stock ETF (VXUS)$69 billion0.08%
Vanguard Total World Stock ETF (VT)$35 billion0.07%
3 more rows

Who should invest in ETFs? ›

ETFs are good for beginners because they offer entry-level access: You can buy as little as a single share, and with some brokers, like Robinhood, you can even buy fractional shares. Fees vary by broker, but it's best to look for options with very low or no transaction costs.

How many ETFs should I own as a beginner? ›

Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification.

Which ETF is best for beginners? ›

ETF Examples: 10 of the Best ETFs for Beginners
  • Vanguard S&P 500 ETF (VOO -0.07%) -- Large U.S. companies.
  • Schwab U.S. Mid-Cap ETF (SCHM 0.1%) -- Midsize U.S. companies.
  • Vanguard Russell 2000 ETF (NYSEMKT:VTWO) -- Smaller U.S. companies.
  • Schwab International Equity ETF (SCHF -0.21%) -- Larger non-U.S. companies.

What do you actually own when you buy an ETF? ›

There is no transfer of ownership because investors buy a share of the fund, which owns the shares of the underlying companies. Unlike mutual funds, ETF share prices are determined throughout the day. A mutual fund trades only once a day after market close.

Should you invest in both ETFs and stocks? ›

The bottom line. An investor looking to build a well-diversified portfolio doesn't have to choose between stocks and ETFs. Instead, understanding the different investment options, tax implications and more can help you build a strategy to meet your financial goals.

Are funds safer than ETFs? ›

In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure.

What is the average return on an ETF? ›

What is the Average ETF Return? The average ETF return will vary depending on each fund's strategy and goals. However, broad market ETFs generate an average return between 7-10%. You can invest in ETFs that track specific types of stocks, such as high dividend-paying companies.

Do ETFs pay dividends? ›

ETF issuers collect any dividends paid by the companies whose stocks are held in the fund, and they then pay those dividends to their shareholders. They may pay the money directly to the shareholders, or reinvest it in the fund.

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