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It’s imperative that you invest for your future. But when it comes time to build your 401(k) or individual retirement account, the investment options can be overwhelming.
There are countless ways to allocate your money in the market. Two of the most popular are individual stocks and exchange-traded funds. Which is best for you depends on your risk tolerance, financial goals and knowledge of the market.
What Are Stocks?
Stocks, also known as equities, signify ownership in a company. When you buy stocks, you basically become a partial owner. You can buy shares of small companies and leading companies, including household names like Nike, The Coca-Cola or Apple.
By buying shares of stock, you can earn money in several ways:
- Capital appreciation: After buying stock, you may find that the price of each share increases over time. This increase is known as capital appreciation.
- Dividends: Some companies pay dividends to their shareholders, meaning they pass on a percentage of their profits. For example, a company may pay a dividend of $0.20 per share.
Stocks are bought and sold on major stock exchanges, such as the New York Stock Exchange or the Nasdaq. You can buy and sell shares during the exchanges’ trading hours, and some brokerages allow you to take advantage of pre- or after-market trading.
Some companies offer direct stock purchase plans that allow you to buy shares without a brokerage account. But generally, you’ll need to open a brokerage account so that you can invest in stocks and trade your shares.
What Are ETFs?
When you buy a stock, you invest money in a single company. While you can invest in many companies, with stocks, you need to buy the shares of each company individually.
Exchange-traded funds work differently. When you invest in ETFs, you invest in many securities rather than just one company. An ETF can be made up of hundreds or even thousands of stocks, bonds or other assets, allowing you to diversify your portfolio with a single investment.
For example, among the world’s best growth ETFs, you might find the Vanguard Growth Index Fund ETF (VUG), which invests in over 250 stocks in several industries, including consumer goods, healthcare and technology. By investing in a single share of this ETF, you get exposure to hundreds of companies.
Like stocks, ETFs are bought and sold on major stock exchanges throughout the day. You can earn money through capital appreciation, and with some ETFs, you can even earn dividend payouts.
To purchase ETFs, you need to have a brokerage account to facilitate transactions for you.
ETFs vs. Stocks: 4 Key Differences
Although stocks and ETFs have some similarities, they’re very different from each other. When deciding how to invest your money, keep these four key differences in mind:
1. Assets
With stocks, you invest in just one company at a time. But with ETFs, you can buy many different kinds of assets at once. ETFs can invest in stocks, bonds, real estate, cryptocurrencies, precious metals and more. Some ETFs contain a mix of securities so you can get exposure to different assets with a single investment.
2. Diversification
When you buy a stock, you’re investing in only one company. If the company underperforms, you could lose your entire investment, so investing in individual stocks can be risky.
With an ETF, you have broader market exposure, and your portfolio is more diversified since you’re investing in a basket of securities. A diversified portfolio can protect you against losses if a particular company or asset fails.
For example, Amazon is one of the biggest companies in the world. But if you’d put all of your money into Amazon stock at the beginning of 2022, you might have lost a significant amount of money. Amazon’s stock price was down more than 30% from April 2022 to April 2023.
But let’s say you invested in an ETF instead. A popular choice is the Vanguard Consumer Discretionary ETF (VCR). This ETF invests in over 300 companies, but Amazon is one of the largest holdings within the fund, so you still get to invest in Amazon. But because the fund invests in so many other companies that offset Amazon’s losses, you’d lose less money by investing in VCR rather than Amazon directly. VCR’s price dropped just 15% over the same period.
Even if you look at the longer-term results, the ETF beats out Amazon. From 2018 to 2023, Amazon’s stock price went up 42%, while VCR’s price was up 54% over the same five years.
In fact, if you’d invested $1,000 into VCR in April 2018, five years later, you would have had $1,547.22. On the other hand, if you’d invested that $1,000 into Amazon stock in April 2018, five years later, you would have only had $1,420.93.
3. Cost
Although it’s possible to create your own diversified portfolio of individual stocks, it can be costly. You’d have to buy shares from many companies. In fact, experts say you’d need at least 30 stocks to diversify your portfolio. However, the cost of buying individual stocks can be significant. With an ETF, on the other hand, you can buy shares and invest in hundreds of securities quickly and with a much lower initial investment.
4. Management
With individual stocks, you—or a professional investment adviser—have to select which stocks to buy and sell. As the market changes, you have to buy and sell shares to rebalance your portfolio.
ETFs can be more passive. You can invest in index funds that track major market indices, or you can use a robo-advisor that manages your portfolio for you to remove some of the stress and work.
How to Choose the Right Investment Type
ETFs vs. stocks: which is best for you? When deciding on an investment type, consider your current financial situation, goals and risk tolerance. If you don’t have a diversified portfolio already, building one on your own with individual stocks can be expensive and time-consuming, and it may require ongoing management.
With ETFs, you can instantly diversify your portfolio by buying shares of the ETF, so you can invest in a variety of securities at a lower cost. Plus, ETFs can be passive, so they tend to be better for hands-off investors.
If you need help choosing investments for your retirement fund or taxable brokerage account, consult with an investment professional to get personalized guidance.
