ETFs vs. Stocks: What’s the Difference?

In finance, there are a wealth of closely related products.

These investment vehicles––which include exchange-traded funds (ETFs), stocks, bonds, mutual funds, and more––are designed to cater to various risk tolerances, investment horizons, and financial goals. Understanding the nuances and interconnections between every product is crucial for any novice investor. That’s because each product comes with its own set of risks and rewards, influenced by market dynamics, economic conditions, and individual company performance.

In fact, people new to investing generally get confused between these and often ask, “What’s an ETF stock?” However, this isn’t quite the right question. In this guide, we’ll focus on ETFs and stocks, clarifying what they are, how they’re alike and different, and their pros and cons.

What’s an ETF, and what are ETF investments?

ETFs are much like mutual funds or index funds. They typically track indices, sectors, commodities, or asset classes, allowing investors to gain exposure to a range of assets through a single purchase.

Unlike other kinds of funds, trading and investing in ETFs is simple and easy because these investment vehicles trade on stock exchanges and can be bought and sold just like individual stocks. This means ETFs are more liquid and accessible and generally less expensive than mutual funds.

Best of all, ETFs are incredibly diverse. There are equity ETFs, bond ETFs (which follow fixed-income securities), sector-specific ETFs, and many other types, including exotic vehicles that employ derivatives to multiply returns or provide inverse returns. You name it, there’s an ETF for it!

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What’s a stock?

Individual stocks represent ownership in a company. When you purchase a stock, you buy a piece of that company and gain a claim on its assets and earnings.

Put simply, stocks offer the excitement of being a direct owner and the potential for significant profits, especially when the company's value grows or when companies return capital to shareholders through dividends.

Also, stocks trade on stock exchanges, such as Nasdaq or the New York Stock Exchange (NYSE), and can be purchased in virtually any quantity. For example, you can buy a single share of Apple, 10,000 shares of a tiny microcap, or 100 shares of ExxonMobil.

ETFs vs. stocks: Similarities and differences

Both ETFs and stocks share some common ground, particularly in how they are traded, but their differences are significant and can influence an investor's decision based on their individual financial goals, risk tolerance, and investment strategy. 

Here are their key similarities and differences:

Similarities

Ownership

Investing in ETFs or stocks means investors become owners of a portion of an underlying asset. When they purchase a stock’s shares, they own a piece of the company. Similarly, buying an ETF’s shares means they have a stake in its underlying assets.

Market exchange

Both ETFs and stocks trade on stock exchanges. This means investors can buy and sell them during trading hours at market prices.

Profit potential

ETFs and stocks offer handy profit potential. If the value of an ETF’s underlying assets or a company’s stock price increases, investors can realize gains by selling their holdings at a higher price than they paid.

Dividends

Another common trait is the income potential. Stocks pay dividends when the underlying companies generate profits and decide to distribute a portion of those earnings to shareholders. 

Likewise, certain ETFs may contain dividend-paying assets, such as dividend stocks or bonds, and pass these income streams to investors.

Differences

Diversification

ETFs provide investors with instant diversification. These funds typically hold a diversified asset portfolio to include stocks, bonds, commodities, or some combination of these. 

In contrast, stocks represent ownership in a single company, meaning their performance is closely tied to the fortunes of that specific business. The degree of diversification in a stock investment is limited to that company's operations and performance.

Management

ETFs are managed funds, and professional fund managers make their investment decisions. These managers select and oversee the assets within the ETF, deciding on the portfolio's composition and making adjustments based on the fund's objectives. 

Stocks, on the other hand, provide investors with direct ownership of a specific company. Shareholders of individual stocks may have voting rights, allowing them to participate in certain company decisions, especially during annual meetings.

Risk and volatility

Individual stocks are generally riskier and more volatile than ETFs. A single company's stock price can experience significant fluctuations due to the company's financial performance, internal news, or broader market conditions. 

While ETFs aren’t without risk, their diversified portfolios tend to make them less volatile, making them an appealing option for risk-averse investors or those seeking more stable returns.

Pros and cons of ETFs

ETFs are known for their unique blend of flexibility, diversification, and accessibility. While they offer a distinct approach to investing that combines elements of mutual funds and stocks, they’re like any financial instrument and come with their own set of advantages and disadvantages.

Here are a few benefits and challenges of ETFs:

Pros

• Increased diversification: ETFs allow investors to maintain a basket of assets––including stocks, bonds, or commodities––helping them spread their risk across various holdings and reducing their exposure to individual asset performance.

• More liquidity: As ETFs trade on stock exchanges, they tend to generate high liquidity, allowing investors to buy and sell shares easily during market hours at market prices.

• Low expense ratios: ETFs typically have lower expense ratios than mutual funds. This means investors pay fewer fees, retaining more of their returns.

• Improved flexibility: ETFs cover various asset classes, sectors, and geographic regions. This means investors have the flexibility to choose from a wide variety of funds that align with their specific investment goals and strategies.

• Better transparency: ETFs disclose their holdings daily, giving investors transparency about their assets.

Cons

• High trading costs: While ETFs typically have lower expense ratios, investors may incur trading costs like brokerage commissions when buying and selling ETF shares. Frequent trading can add up in terms of expenses.

• Increased tracking errors: ETFs track the performance of an underlying index or sector, but factors like fees and trading costs can cause a slight disparity called a tracking error. This means the ETF’s performance may not precisely match the index’s performance it tracks.

• Overemphasis on popular assets: Some ETFs may heavily focus on popular assets or sectors. This can lead to overemphasis and potential bubbles, which might result in losses if the sector or index experiences a downturn.

Pros and cons of stocks

Stocks offer a direct path to owning a piece of a company's future and are often celebrated for their potential to yield significant returns and bring investors closer to the businesses they believe in. But investing in stocks is not without its complexities and risks.

Here are a few advantages and disadvantages of investing in stocks:

Pros

• Potential for high returns: Stocks possess the potential to generate significant capital appreciation over time. Successful companies can provide substantial returns on investment, making stocks attractive for long-term investors.

• Opportunity for dividends: Many large, stable companies pay dividends to their shareholders. This provides investors a steady income stream, making stocks appealing to income-minded investors.

• Better control and flexibility: Investing in individual stocks grants investors control over their portfolios. They can build a personalized and targeted investment strategy based on their research, preferences, and financial goals.

Cons

• High volatility: Stocks can be highly volatile. Prices are influenced by market sentiment, economic factors, and company-specific news.

• Potential to go to zero: Because individual companies can fail, there’s a small but real chance that your investment in a stock can drop in value, perhaps all the way to zero.

• Lack of diversification: Investing in individual stocks lacks the built-in diversification offered by ETFs, leaving investors exposed to the performance of a single company or sector.

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