Stocks vs. ETFs: Which is Better?
Stocks and Exchange-Traded Funds (ETFs) are two of the most popular assets in the financial market today. Indeed, a large portion of Americans own stocks and ETFs directly and indirectly in the US. Indirectly, they own these assets through their retirement accounts. In this article, we will look at the similarities and differences between the two and then identify the better option to invest in.
What are stocks, and how do they work?
Stocks, also known as shares, are parts of a company. For example, if you start a company today and raise $1 million by selling 10% of the company to venture capital firms, it means that the entire firm is valued at $10 million.
After a few years, you may want to take the company public through an initial public offering (IPO), merging with a special purpose acquisition company (SPAC), or through a direct listing. In this case, the company will become a publicly traded firm, and its shares can be traded in the open market.
Stocks rise and fall whenever the market is open. This happens because there are always buyers and sellers in the financial market. Buyers believe that the shares will keep rising while sellers do so in a bid to take profit or find opportunities elsewhere.
Investing in stocks can be a lucrative thing. For example, Warren Buffett has been a successful investor for more than 60 years. During this period, he has rarely invested in other assets like bonds and gold.
What are ETFs, and how do they work?
Exchange-Traded Funds (ETFs) are financial products that track one or more stocks, bonds, currencies, commodities, and cryptocurrencies. There are two main types of ETFs. First, there are active funds, where a fund manager is at liberty to buy and sell shares in the fund. One of the best-known active ETFs is Ark Innovation Fund (ARKK). It is a fund that invests in some of the best-known tech firms like Tesla, Teladoc, and Zoom Video.
Second, there are passive ETFs, which track already-established indexes. For example, Invesco QQQ is a fund that tracks the Nasdaq 100 index. Similarly, the Vanguard S&P 500 index tracks the S&P 500. This is why its performance and that of the iShares S&P 500 index are the same.
Stocks vs. ETFs similarities
Stocks and ETFs are similar entities. First, the two assets are listed in popular exchanges like the New York Stock Exchange (NYSE) and Nasdaq. This means that you can buy stocks and ETFs in a similar way using your favorite brokers like Robinhood and Schwab.
Second, there is a wide variety of stocks and ETFs. For example, in the United States, there are more than 5,000 stocks that you can invest in. Similarly, there are thousands of exchange-traded funds that you can invest in today. Most of these funds are created by large companies like Blackrock and Vanguard. Others are created by smaller firms like Direxion and ProShares.
Third, the two are offered for free by most brokers. Popular brokers like Robinhood and Schwab have eliminated fees for stocks and ETFs. However, a key difference is that many ETFs charge an expense ratio. This ratio goes to cover the costs of running the fund. Active ETFs charge a higher expense ratio than passive ones.
Another similarity is that you can go long or short on the two assets. When you go long for an asset, it means that you believe that its price will keep rising. On the other hand, when you short it, it means that you believe that its price will retreat.
Most importantly, depending on the stock or ETF that you buy, you can receive dividends. For example, stocks like Microsoft and Procter & Gamble pay a dividend. Many ETFs pay a dividend as well.
Stocks vs. ETFs: better buy?
So, which one should you buy between stocks and ETFs? The answer to this will depend on the type of trader that you are and the expected returns. If you are a short-term investor who wants to get bigger returns, then stocks are for you. For example, people who invested in stocks like Apple, Microsoft, and Tesla when they went public have seen excellent returns.
On the other hand, if you are a risk-averse investor, then investing in ETFs makes sense. This is because ETFs tend to have more assets. As such, a drop in one stock will be offset by a sharp increase in the other. Therefore, ETFs tend to be relatively calmer than stocks.
A good example of this situation is shown in the chart below. In it, we see that the Snap stock price crashed in the final week of October 2021. The 33% drop happened after the company published weak quarterly results. Therefore, investors who were long the stock saw 33% of their value evaporate. On the other hand, the ProShares Ultra ETF (ROM) continued to do well. This is despite the fact that Snap is a major constituent of the fund.
Second, ETFs provide a relatively cheaper option to get a diversified portfolio. For example, if your goal is to invest in growth stocks, investing in the iShares Core Growth Fund (XGRO) can give you exposure to the biggest growth stocks in the industry. The alternative is to buy all these stocks individually.
Another difference is that stocks are just one asset class. Exchange-traded funds, on the other hand, can be made of different assets like bonds, commodities, and even currenciesю
Summary: Which is a better option?
Stocks and ETFs are two of the most popular assets that you can invest in today. In the long term, single stocks can make better investments than ETFs. This will happen provided that the stock continues doing well. On the other hand, ETFs provide relatively modest returns over the years. They achieve this by spreading the risk among multiple companies and other assets.
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