Stocks vs. ETFs: Which should you invest in?

If you’re getting started investing, you might wonder whether it’s better to invest in stocks or ETFs. Well, the answer depends. Stocks can be a great investment in some circumstances, while ETFs can be better in others. But for new investors, exchange-traded funds solve many problems, and they’re an easy way to earn attractive returns — so they’re a great starting point.

Here’s all you need to know about stocks vs. ETFs and when it’s best to use each one.

Stocks and ETFs: How they differ

Stocks and ETFs are similar in some ways, not surprisingly, since ETFs often contain many stocks. Despite their likenesses, they’re fundamentally different and present various upsides and risks.

Stocks

A stock represents a fractional ownership interest in a business and typically trades on an exchange, in the case of a publicly traded company. When you own a stock, you’re investing in the success of that company — and only that company.

In the short term, stocks may rise and fall for many reasons, and market sentiment often determines how a stock performs day to day. In the long term, however, a stock more closely follows the company’s growth. As the company expands its profits, the stock will tend to rise as well.

Individual stocks can perform phenomenally over time, but they may be volatile in the short term, fluctuating massively. It’s not unusual for high-flying stocks to decline 50 percent in a given year on their way to long-term outperformance. On the other hand, a strong stock might go up 50 percent or more in a single year, especially if the overall market is hot.

ETFs

ETFs are collections of assets, often stocks, bonds or a mix of the two. A single ETF might own dozens, sometimes hundreds, of stocks. So by owning a single share of the ETF, investors can own an indirect stake in all the stocks (or other assets) held by the fund. It’s a great (and often inexpensive) way to buy a collection of stocks.

ETFs often invest in stocks that have a specific focus area, for example, large companies, value-priced stocks, dividend-paying companies or those operating in a specific industry, such as financial companies. Some specialized ETFs allow you to potentially earn higher returns.

Most ETFs are passively managed, meaning that they replicate a specific index of assets, such as the S&P 500, a collection of hundreds of America’s largest companies. The ETF changes its holdings only when the underlying index changes its constituents.

Because of their wide array of holdings, ETFs provide the benefits of diversification, including lower risk and less volatility, which often makes a fund safer to own than an individual stock.

An ETF’s return depends on what it’s invested in. An ETF’s return is the weighted average of all its holdings. So if it owns many strong stocks, the ETF will rise. If it owns many poorly performing stocks, then the ETF will decline, too.

The table below shows some of the key differences between stocks and ETFs.

The pros and cons of stocks

Investing in a stock can offer a lot of benefits, though it’s not without some serious drawbacks.

Advantages of investing in stocks

• Investing in an individual stock can deliver very high returns, and you won’t be taxed on any capital gains until you sell, in a taxable account.
• A single stock can potentially return a lot more than an ETF, where you receive the weighted average performance of the holdings.
• Stocks can pay dividends, and over time those dividends can rise, as the top companies increase their payouts.
• Companies can be acquired at a substantial premium to the current stock price.
• Commissions on stock trading have been slashed to zero at major online brokers, meaning it doesn’t cost anything to get in and out of an investment.
• Investors who hold a stock for more than a year may enjoy lower capital gains tax rates.
• You can still own the wealth-building power of stocks within an ETF or mutual fund.

Disadvantages of investing in stocks

• Stocks can fluctuate a lot from day to day and month to month, meaning you may need to sell at a loss and may never recover what you invested.
• Volatility can be dangerous for investors who have all their wealth tied up in just one or a few stocks. If that one stock does poorly, the investor has a lot of eggs in one basket and can lose a significant portion of wealth.
• Stocks aren’t an investment guaranteed by the government, so you may lose all your money.
• Because an individual stock tracks the performance of the company over time, you have to own a winning company to make money. Pick a loser and you’ll lose money.
• Much effort is required to analyze and value individual stocks, and many people simply don’t have the time or desire to do so.
• You’ll need to pay taxes on any capital gains you generate, though you also have the ability to write off losses and get a tax break.

The pros and cons of ETFs

ETFs offer plenty of benefits to investors, whether they’re new to the game or are more advanced, though these funds don’t come without some drawbacks.

Advantages of investing in ETFs

• ETFs allow you to buy one fund and have a stake in dozens or even thousands of companies.
• Because of this broad ownership, ETFs offer the power of diversification, reducing your risk and increasing your returns.
• A well-diversified ETF such as one based on the S&P 500 can beat most investors over time, making it easy for regular investors to do well in the market.
• 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.
• ETFs can be bought and sold any time the market is open, giving you a highly liquid asset.
• ETFs can be traded at no cost at most major online brokers.
• It takes little investing expertise to invest in ETFs and earn high returns.
• You won’t be taxed on any capital gains until you sell the ETF in a taxable account.
• Like stocks, ETFs can pay dividends.

Disadvantages of investing in ETFs

• ETFs, even in a good year, will underperform the best stocks in the fund, meaning investors could have owned just those stocks and done better.
• ETFs do charge an incremental cost, the expense ratio, for owning the fund.
• Not all ETFs are the same, so investors do have to understand what they own and what it could return.
• Like stocks, the investment performance of ETFs isn’t guaranteed by the government and you could lose money on the investment.
• You can’t control what’s invested in any single fund, though of course you don’t have to buy shares in that fund either.

ETF vs. stock: Which is better for your portfolio?

Buying individual stocks or ETFs can work better for individual investors in a variety of scenarios, and here’s when each one shines:

When stocks are better

• You enjoy analyzing and following individual companies. It takes a lot of work to follow a stock, understand the industry, analyze financial statements and keep up with earnings. Many people don’t want to spend this time.
• You want to find outperformers. If you can find the stocks that will outperform — for example, Amazon or Microsoft — you can beat the market and most ETFs.
• You’re an advanced investor with time to devote to investing. Many investors enjoy following companies and tracking them over time. If that’s you, then buying individual stocks may be a great option for you.

When ETFs are better

• You don’t want to spend much time investing. If you’re looking for an easy solution to investing, ETFs can be an excellent choice. ETFs typically offer a diversified allocation to whatever you’re investing in (stocks, bonds or both).
• You want to beat most investors, even the pros, with little effort. Buy an ETF based on the S&P 500 and you’ll wind up beating the vast majority of investors over time. That’s right, passive investing with ETFs generally beats active investing.
• You don’t want to analyze individual companies. If you have no desire to follow business, then pick an ETF or a few, and add to them over time.
• You’re a new or intermediate investor. ETFs are great for investors who are getting started, helping reduce your risk as your knowledge gets up to speed. But even many advanced investors use them, too.
• You want to invest in a specific trend without picking winners. Is there a hot new industry but you’re unable to pick which company will come out on top? Buy an ETF and get exposure to the whole sector at low cost.

Of course, it’s possible for investors to do both of these strategies. For example, you could have 90 percent of your portfolio in ETFs and the remainder in a few stocks that you enjoy following. You can hone your skills at investing in individual stocks without hurting your returns much. Then, when you’re ready you can shift to more individual stocks and away from ETFs.

Bottom line

ETFs make a great pick for many investors who are starting out as well as for those who simply don’t want to do all the legwork required to own individual stocks. Though it’s possible to find the big winners among individual stocks, you have strong odds of doing well consistently with ETFs. Of course, you can blend the two methods as well, getting the benefits of a diversified portfolio with the potential extra juice from a few individual stocks on the side, if you want to try your skill.

Note: Bankrate’s Rachel Christian also contributed to this story.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.