Just about everyone enjoys receiving flowers — whether it’s a single long-stemmed rose or a bouquet bursting with a variety of blooms. Both options are beautiful in their own unique way.
While investments might not be as aesthetically pleasing (nor do they smell quite as nice) as flowers, you can think of them similarly: Stocks are individual blooms, and exchange-traded funds (ETFs) are an expertly arranged bouquet of similar or complimentary stocks.
And just as you might have trouble deciding whether gardenias or tulips are the right choice to give to your significant other, you may be unsure whether to invest in stocks vs. ETFs.
Both options offer pros and cons, and when it comes down to it, there’s typically space for both in your portfolio garden. But before you begin picking, you first want to know the basics, as well as what goes into the tending of both of these investment types.
What are stocks?
A stock is an investment security that represents a share of ownership in a company. When you buy stock in a company, you become a shareholder.
If stocks are flowers, think of one share of a tech stock like Apple, for example, as a daisy. You can pick just one daisy or a bunch, but each looks the same, just like each share from the same company look identical. And if you purchase more than one share at the same time, they’ll cost the same, too.
Typically, you purchase stocks you believe will increase in value. That way, when the share is sold, you make a profit. (You may have heard the rule: buy low, sell high.) Some stocks also provide income through dividends, or regular payments (typically quarterly), of the company’s earnings issued to shareholders.
What are ETFs?
ETFs are basket-like securities that allow you to invest in numerous holdings through one purchase. They hold a combination of stocks from different companies (or other assets, like bonds) that are related in some way — like a bouquet combines an array of different flowers typically related by season or color palette.
An ETF typically tracks an index (like the Dow Jones or S&P 500), meaning all the securities held within the ETF can be found on that index. Or, an ETF may invest in holdings all from a certain industry, like technology or energy.
While ETFs have professional fund managers, they’re often passively managed since they track and replicate the behavior of indices. That allows them to have lower expense ratios, or costs to manage, than other types of actively managed funds (like mutual funds).
How are stocks and ETFs similar?
ETFs and stocks have a number of similar characteristics. Both are traded on stock exchanges and usually require you to go through brokerage firms, like Ally Invest, to buy or sell. Prices of stocks and ETFs can fluctuate during the day, based on supply and demand in the stock market.
While you can buy and sell these investments throughout the day (rather than just once at market close), some brokers charge a commission fee each time you trade ETFs or stocks. Depending on your investment strategy, these fees could add up. That’s why we offer many commission-free ETFs and stocks through our Self-Directed trading platform.
Just like individual stocks, some ETFs may issue dividend payments. If you’re receiving dividends from either kind of investment, you’ll have to pay tax on the income. You will also have to pay a capital gains tax on the profits made from selling both ETFs and stocks.
Risk and Diversification with Stocks and ETFs
Investing always comes with some inherent risks, and different types of securities and asset classes may be riskier than others.
Stocks are often thought of as a riskier investment, because the success of your investment relies solely on the success of one company. Stocks are susceptible to market volatility due to a number of factors, like changing consumer preferences, natural disasters that may impact the economy, etc. And of course, it’s possible for any company to go bankrupt or go out of business.
When it comes to stocks vs. ETFs, certain qualities of ETFs can help mitigate the risk associated with investing. Because ETFs are made up of many securities, you are less dependent on the success of individual companies. So even if stock from one business in the fund fails, the rest of the ETF will likely be minimally affected, or not at all.
This concept is known as diversification. It’s a key investment strategy that helps lower your risk by spreading out investments across different industries and asset classes. One of the major advantages of ETFs is they’re automatically diversified because they contain securities of numerous companies.
While you can build a diversified portfolio of stocks, an ETF portfolio may be a more efficient way to ensure you have investments in different types of companies. But keep in mind: Because the securities within an ETF are usually related by index or sector, they’re often affected by the same market influences. So just because you’ve invested in one ETF, doesn’t mean your portfolio is diversified.
To achieve overall diversification, a mix of asset classes (or different types of investments, like equities, bonds, commodities, etc.) is usually your best bet. By combining stocks and ETFs, you can invest in a variety of industries and asset classes to lower your risk and strengthen your returns.
Stocks vs. ETFs: Which should I invest in?
Stocks and ETFs each have pros and cons — and both can be beneficial to your portfolio. If you’re trying to decide between investing in individual stocks vs. ETFs, you should consider your investment goal. Are you dipping your toes in investing for the first time or are you a long-term investor funding a retirement plan? Do you want to experiment with investment strategies or try to beat the market?
Both of these investment types often provide the best results when you invest over a longer period of time. The lengthier your time horizon, the more risk you can typically take on. Why? Because your investments aren’t as affected by short-term market ups and downs (aka volatility). So if you are investing to build your retirement nest egg (and still have plenty of years to go), either of the options could be good for your portfolio.
Certain types of ETFs, like leveraged ETFs, can provide a more substantial return when investing for the short term — as in typically just one day. Investing in and trading ETFs like this can be tricky (and risky) and might be suited to more advanced investors.
If you want to expand your portfolio into new types of investment, like gold, lumber, or a foreign currency, ETFs could be a great starting point. That’s because you can invest in many types of ETFs, like commodity ETFs or forex ETFs. These can help you enter a sector you may not be as familiar with, without having to put all your eggs in one stock’s basket.
Investing in individual stocks may be a good idea for you if you have substantial market knowledge and have done research on a particular company. Or, if you have a high risk tolerance, you may choose to invest in certain select stocks rather than an exchange-traded fund.
While one red rose can deliver just as strong an impact as a bouquet of wildflowers — if you can have both, even better. The same goes for ETFs and stocks. Their unique qualities make each beneficial in helping you reach your investment goals. And when you have both in your portfolio, you can achieve even more.
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