As a trader, you may have traditionally stuck with stocks as your main trading vehicle but you may have witnessed an explosion of ETFs or Exchange Traded Funds entering the markets since the beginning of the 21st Century. I’ll assume you have a basic understanding of stocks and ETFs in this article (please click here if you need a refresher on the benefits of ETF trading and investing.)
Advantages of Stocks
Individual stocks are more volatile which gives them greater profit potential than the typical ETF. Individual stocks also tend to be more predictable than ETFs which usually contain a basket of stocks and other securities (but don’t mistaken this to mean that they’re safer.) This makes stocks better candidates for event-driven strategies which rely on exploiting market mispricings; it’s a bit difficult to assess the fair value of an ETF that contains dozens of stocks.
Disadvantages of Stocks
Well, what’s more fragile, an investment in a single company or an investment in a group of companies? While the former can offer you tremendous upside especially if you happened to pick the next Apple, Tesla, Microsoft, Google, etc. it also offers tremendous downside if any catastrophe hits the stock you’re holding (i.e. Lehman Brothers in 2008) or even a simple earnings miss or analyst downgrade. In 2014, GTAT (GT Advanced Technologies) went bankrupt and lost over 90% of its value in a matter of days and plenty of people lost a majority of their life savings due to it! Now you might be thinking you’d be smarter and hold 5-10 stocks instead of putting everything into 1-2 baskets. Yes, you’d be less exposed to catastrophic losses but you’d also have more securities to monitor and additional trading commissions to pay. If you want to go this route, unless you’re trading full time and can constantly monitor each stock, you’re probably better off trading an ETF index fund rather than swing trading a basket of several stocks at once.
Most people might think of ETFs as a diverse collection of stocks packaged into a single security that can be traded in and out of like a stock but that’s just one type out of many. There are ETFs for different asset classes like Gold, Treasuries, Real Estate, etc. as well as different strategies (2-3x Leveraged, Inverse/Short, Covered Calls, Hedged Foreign Indices, etc.) The former offers you diversification benefits without the commissions and trading costs: imagine buying a market cap weighted portfolio of the S&P500 and rebalancing it regularly to reflect the index – the commissions will easily kill your returns even if you’re holding a 1 million dollar portfolio in a discount brokerage account! On the other hand, the ETF manager can take advantage of their economies of scale and pass down the savings in a relatively negligible fee.
ETFs, IMO, are probably one of the best financial innovations since the 1990s because they offer the retail trader diversification benefits for minimal cost AND similar liquidity to stocks (unlike mutual funds.) But the ETFs that invest in alternative asset classes like gold and treasuries are where things really shine. It’s now possible to keep a well diversified portfolio consisting of multiple asset classes in a single location like one discount brokerage account instead of being spread out over multiple accounts thanks to these ETFs!
Disadvantages of ETFs
ETFs can be complex instruments due to the variety of securities they hold plus the plethora of investment strategies that some of them pursue, esp leveraged and short ETFs. Some ETFs have substantial fees, particularly the ones involving alternative investments and active management, although they’re usually nowhere near what Mutual Funds charge. ETFs also don’t offer the same upside potential as owning a “winning” individual stock.
My Thoughts
If you’re pursuing a buy and hold or swing trading strategy, ETFs are likely more suitable since you won’t be exposed to the rare but devastatingunsystematic risks that afflict stocks. In other words, you probably won’t be losing sleep over whether your investment will drop 50% or more overnight. For a seasoned day trader who isn’t holding any positions overnight, trading individual stocks may prove to be more lucrative. But if you’re a beginner, even when day trading, just stick with ETFs for now.
What Is a Stock Pick? A stock pick is when an analyst or investor uses a systematic form of analysis to conclude that a particular stock will make a good investment and, therefore, should be added to their portfolio.
offers an advantage over exchange-traded funds (ETFs) when there is a wide dispersion of returns from the mean. Exchange-traded funds (ETFs) offer advantages over stocks when the return from stocks in the sector has a narrow dispersion around the mean.
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.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.
The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.
ETFs are most often linked to a benchmarking index, meaning that they are often not designed to outperform that index. Investors looking for this type of outperformance (which also, of course, carries added risks) should perhaps look to other opportunities.
Theoretically, for exotic ETFs, yes — but as a practical matter highly unlikely. And for broad market ETFs that track something like the S&P 500 Index the probability of going to zero is, well, about zero. Every stock in the index would have to go to zero.
Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.
Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.
Some funds, such as money market funds or certain exchange-traded funds (ETFs), are highly liquid and allow for same-day or next-day withdrawals. On the other hand, certain alternative investment funds or funds with lock-up periods may have limited liquidity, making it difficult to withdraw your money immediately.
ETF issuers collect any dividends paid by the companies whose stocks are held in the fund, and they then pay those dividends to their shareholders. They may pay the money directly to the shareholders, or reinvest it in the fund.
The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors might be 100% invested in equity ETFs when they are in their 20s.
The bottom line. An investor looking to build a well-diversified portfolio doesn't have to choose between stocks and ETFs. Instead, understanding the different investment options, tax implications and more can help you build a strategy to meet your financial goals.
Diversification. One ETF can give investors exposure to many stocks from a particular industry, investment category, country, or a broad market index. ETFs can also provide exposure to asset classes other than equities, including bonds, currencies, and commodities. Portfolio diversification reduces an investor's risk.
Key Takeaways. Not all ETFs offer the criteria for short-term trading, which includes high liquidity, cost efficiency, and price transparency. To maintain liquidity, traders should avoid ETFs that have a high percentage of off-exchange trades.
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