So, you’re considering trying your hand in the stock market. You’ve done a ton of research but you feel overwhelmed with the number of stocks on the market to choose from. Where do you start and how do you go about managing risk?
As is the case with most questions in the world of finance, there’s no one-size-fits-all answer to this question. The best solution for you depends on your goals, knowledge of the market, and hunger for control over your investment portfolio.
Are Individual Stocks or ETFs Best?
Both stocks and ETFs are traded on stock exchanges like the Nasdaq and New York Stock Exchange (NYSE), and they happen to be two of the most popular asset classes. But they’re quite different from one another.
So, which is best for you?
The answer depends on a number of factors.
Your money is yours, and you’re used to having control over it. When investing in stocks, you have complete control over what you choose to invest in, which dictates what happens with your money. Conversely, when investing in ETFs, you give up a lot of your control over your money.
Here’s how it works:
Investing in Stocks Gives You More Control
Investing in stocks gives you the ability to invest in any particular stock you’d like exposure to. When making that investment, you’ll be able to buy as many shares as you’d like and follow any investment strategy you deem fit. As a result, when you invest in stocks, you have complete control over where your money goes.
That’s not the only control investing in individual stocks gives you.
When you make an investment in a stock, you own a small portion of that company. So, when the company wants to change its business model, is considering selling itself to a larger fish in the pond, or wants to give its management team higher compensation, you’ll usually have a vote depending on the class of shares you own.
Investing in ETFs Gives up Some Control
Exchange-traded funds pool investments from a large group of investors and use those funds to invest according to the investment strategy outlined in the prospectus for the fund. So, when investing in these funds, you’ll be giving up control over which stocks are purchased using your investing dollars.
You also don’t enjoy voting power when you invest in ETFs. Sure, as an investor in a fund, you’ll have a small piece of ownership in every company the fund has within its investment portfolio. But the votes given to those investments aren’t yours — instead, the fund manager acts on your behalf by placing a vote for you when important matters are up for shareholder approval.
This doesn’t mean you completely give up control over your investments when you invest in ETFs. There are plenty of ETFs on the market, each with their own investment strategy, portfolio, and management team. You can still control where your money goes by choosing which ETF to invest in.
If you’re looking to gain exposure to a particular sector, index, or other benchmark, look for an ETF centered around it. Some funds are even classified by their investment strategy, giving you the ability to gain exposure to growth, dividend, value, and other strategy-based classifications of stocks you’re interested in without having to choose each individual security you invest in.
Pro tip: Earn a $30 bonus when you open and fund a new trading account from M1 Finance. With M1 Finance, you can customize your portfolio with stocks and ETFs, plus you can invest in fractional shares.
Diversification is the process of spreading your investment dollars across a wide range of assets, industries, and asset classes. Diversification is a crucial part of any investment strategy. Ultimately, a heavily diversified list of investments shields you from risks associated with volatility.
Keeping your investments diversified is Wall Street’s way of avoiding putting all your eggs in one basket. This way, if one basket falls, the others keep your nest egg intact.
Diversification Can Be Difficult With Individual Stocks
When investing in stocks, diversifying your portfolio may prove more difficult than you think. The process involves investing in several different companies across multiple different industries.
That may not seem all that difficult — until you consider the amount of research involved in successfully choosing a stock, much less choosing a diverse range of investments.
Extensive research is the basis of any investment decision. Before investing in any stock, you should have a good understanding of the industry the company works within, the historic performance of the stock and of the company, the benefits of the company’s product or service, and the economic moat created by the company’s intellectual property.
That’s quite a bit of research. For many investors, it’s unrealistic to commit the time it takes to do adequate due diligence on the 20 or more different investments needed to build a well-diversified portfolio.
ETFs Provide the Ultimate Diversification
On the other hand, ETFs are highly diversified bucket investments. If you’re interested in investing in every stock on the S&P 500 index, the Nasdaq, or any other market index or benchmark, chances are you’ll find a fund focused on making the types of investments you want to make.
The ultimate goal of any fund manager is to provide investors with a way to access a high-quality diversified portfolio that achieves significant growth with a single investment. Naturally, you’ll be making one of the most diversified investments possible by investing in ETFs.
Moreover, by spreading your investment dollars across a list of ETFs, you’ll be expanding the diversity within your portfolio.
Cost is an important factor when it comes to investing. At the end of the day, it costs money to make money, so there will always be expenses associated with investing. However, it’s important that those costs don’t cut too deeply into your profits.
So, how does choosing your own list of stocks compare with ETFs in terms of cost?
Transaction Fees Add Up on Stocks
Active investing in stocks will likely prove to be more expensive than using a buy-and-hold strategy or investing in ETFs. That’s especially the case if you add a bit of diversity to your portfolio. No matter where you house your brokerage account, there will be fees involved with transactions, even if those fees are baked into the spread instead of charged as commissions.
When investing in multiple stocks, you’ll be paying transaction fees every time you make a trade, which might not seem like much at first glance, but if you buy and sell often, these fees can add up.
ETF Expense Ratios Keep Costs Low
Fund managers go about investing differently than the average retail investor. Because these funds have massive amounts of money to invest, they trade in very large blocks of shares, significantly reducing their cost of investing.
Moreover, many ETFs are passively managed, meaning that highly paid fund managers, traders, and investment analysts don’t need to be on the clock all day, greatly reducing costs of these funds even further.
So, even when accounting for management fees, with expense ratios averaging around 0.44% according to Experian, ETFs are a low-cost alternative to investing in stocks. Vanguard is famous for offering ultra-low-cost funds that help you keep your investing costs to a minimum.
Returns are arguably the most important part of investing. So, how do returns stack up when comparing individual stocks and ETFs?
Individual Stocks Give You the Ability to Beat the Market
When picking your own stocks, you have the ability to target opportunities that have the potential to beat the market. For example, had you invested in Amazon.com or Apple in January 2020, your returns would have easily beaten just about any benchmark you compared them to throughout the month.
During the month, these stocks saw dramatic gains as tech stocks grabbed the attention of the retail investing community.
However, it’s important to note that stock picking can go both ways. While you have the potential to produce higher returns than ETFs, when you make a mistake or encounter a bit of bad luck, your losses could be substantially larger than those produced by diversified funds.
So, investors are able to achieve much higher returns than those investing in ETFs, but the risks associated with doing so should be considered.
You Mirror the Market With ETFs
When investing in ETFs, you don’t have the ability to choose the stocks your money is being invested in. As a result, you won’t be able to jump on the same opportunities that investors in individual stocks can, and your potential returns may be lower than those of expert stock pickers who identify hugely profitable opportunities.
On the other hand, that’s not necessarily a bad thing. The truth is that when you invest in bucket investments like investment-grade funds, your holdings become so diversified that you become a mirror of the broader market. So, your ability to choose a hot stock and beat the market may be limited, but so too will be your losses when events don’t go your way.
Pro tip: Before you add any stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Trade Ideas can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
Liquidity is an important factor to consider when investing. The term relates to how easy it is to exit your investment when the time comes to do so. It’s important to consider liquidity for two reasons:
- Cutting Losses. When an asset you’ve invested in falls on bad news, losses have the potential to happen fast. The speed at which you’re able to get out of the investment and cut your losses could make a huge difference in your bottom line.
- Access to Funds. While investment accounts should never be used as emergency savings accounts, there are some instances where you might need access to money immediately and your investment account is the only place to get it. However, if you’re unable to sell the assets you’ve purchased quickly, you won’t be able to access the funds you need.
Considering these factors, how do stocks compare to funds in terms of liquidity?
Some Stocks May Lack Liquidity
When picking stocks, it’s important to pay close attention to just how liquid they are. To determine this, look at the average daily volume of the stock. If fewer than 1 million shares of the stock trade hands in an average trading session, demand for the stock may be too low to make a speedy exit. This means if the stock takes a dramatic short-term drop, you might find it difficult to sell shares, and may be stuck holding the bag.
On the other hand, if you focus on popular blue-chip stocks — stocks of large, established companies that have a large following — selling your shares when the time comes will prove to be a relatively simple process. On the other hand, penny stocks and small-cap stocks tend to be more lightly traded and lack liquidity.
Most ETFs Are Highly Liquid
Although there are a few small funds on the market that don’t have much demand, the vast majority of ETFs are highly liquid. As a result, when investing in these assets, you’ll be able to access your funds quickly in case of an emergency or a widespread market decline that leads to losses in your holdings.
The Verdict: Should You Choose Stocks or ETFs?
You Should Invest in Individual Stocks If…
Stock picking is the way to go if you’re confident in your understanding of the market and how it works, have time to do the adequate research, and have the stomach for the risk that’s involved in choosing stocks one by one. You might decide to go this route if:
- You Have Time to Manage Your Investment Portfolio. Research is the foundation of your investment decisions, and like a building on a weak foundation, when an investment is made without adequate research, it could crumble, leading to crippling losses. If you have the time to do your due diligence on the several stocks it takes to maintain a highly diversified portfolio, you may want to consider stock picking rather than investing in exchange-traded funds.
- You Have a Deep Understanding of the Stock Market. The stock market is a complex machine, and those who do best on Wall Street have a deep understanding of what makes that machine work. If you’re not quite sure what makes the market tick, and what causes growth or declines, picking stocks isn’t the best option to consider.
- You Can Set Your Emotions Aside. Humans are emotional creatures, and on Wall Street, emotions often become detrimental to returns. So, if you decide you’re going to pick the stocks you’re going to invest in yourself, it’s important that you have the ability to set your emotions aside and stick to your strategy.
- You Have a Strong Stomach for Risk. Picking your own stocks is a riskier way to go about investing than nesting your money into ETFs. Sure, there’s the potential for larger gains, but there’s also the potential for significant declines that could devastate your portfolio. Be honest about your risk tolerance; if you could stomach a big drop in your portfolio’s value, picking individual stocks might be for you.
You Should Invest in ETFs If…
ETFs are the way to go for investors who are just getting started or for seasoned investors who simply don’t have the time to do the detailed research required to make wise investment decisions and maintain a diversified portfolio of individual stocks. Those who invest in ETFs often:
- Want Access Without Arduous Research Requirements. There’s quite a bit you’ll need to know about each company you invest in if you choose to invest in individual stocks, which takes quite a bit of research. However, when investing in funds, the fund manager does the brunt of the research. Although it is important to look into expenses, historic performance, and dividends before diving into any investment-grade fund, you can leave the research into individual companies to the professionals.
- Are Newcomers to Investing. If you’re new to investing, but don’t want to give up precious time and compounding gains while you learn how it all works, investment-grade funds give you the ability to gain access to Wall Street while you educate yourself and prepare to make your own investment decisions.
- Want a Safer Investment Opportunity. Because ETFs are highly diversified, they’re a great option for those looking to play it safe. Sure, there is potential for losses when investing in funds, but due to the heavily diversified nature of these investments, your volatility and liquidity risks are greatly reduced.
- Want Access to Industries You Don’t Know Much About. Investing in what you know is key to making successful decisions, but what if you know a great deal about sectors that are having a hard time and nothing about sectors that are flying? Do you have to miss out on the gains? No! There are ETFs on the market centered around every sector you may be interested in, giving you a way to gain access to booming sectors without a deep knowledge of what makes that industry tick.
Both Are Great If…
In many cases, a good mix of stocks and ETFs is the way to go. If you’re not looking to give up complete control over your investment portfolio, want to invest in a few specific companies and let the pros handle the rest, or want to reduce your volatility and liquidity risks while picking your own investment opportunities, a combination of stocks and ETFs is the way to go. You should consider a mix of funds and stocks if you:
- Want to Invest in a Few Interesting Stocks. If there are a few names on the stock market that you’re very interested in, but you don’t want to choose every stock you own, you can simply make investments in the few stocks you’ve selected with a portion of your portfolio and invest the rest of your investment dollars into diversified, investment-grade funds.
- Have Some Time for Research. Few people have the time it takes to do the research required to maintain a highly diversified portfolio of stocks. However, most people have some time to dedicate to research. If you’re looking to generate market-beating returns but can’t manage your entire portfolio due to time constraints, there’s no shame in investing in a small handful of stocks and subsidizing your portfolio’s diversity with ETFs.
- Want to Spread Your Investments Across Several Sectors. While you may be an expert in one or two sectors, other sectors of the market may be generating compelling opportunities. As a result, you may want to choose the stocks in the sectors you know well and invest in ETFs to gain exposure to booming sectors you’re less familiar with.
Choosing between stocks and investment-grade funds is an important decision. Ultimately, this decision will play a massive role in the returns, costs, and level of risk associated with your investment portfolio.
For many investors, mixing the two asset classes is the way to go.
Regardless of which way you decide you’re going to invest, it’s important to remember that research is the basis of successful investment decisions. Before risking your hard-earned money, make sure to do your due diligence to increase your chances of success.