Stocks represent ownership interest in companies and trade on regulated and over-the-counter markets. Exchange-traded funds track market indexes and trade on the markets just like stocks. ETFs offer broad diversification at reasonable cost. Stock picking is active investing because you have to monitor the fundamentals of each company. Buying an ETF is passive investing because it rises and falls with the corresponding index. There are some advantages to the active investing necessary when picking individual stocks.
You have more control with individual stocks and you can invest in businesses you understand. On the other hand, you have no say in the composition of the indexes tracked by ETFs. With individual stocks, you can research the business fundamentals, earnings history and expectations for upcoming quarters before making an investment decision. It would be difficult to monitor ETFs the same way, because they usually track indexes with dozens of companies. Therefore, the performance of your investment portfolio would depend on circumstances beyond your control.
Individual stocks offer more flexibility because you can pick and choose the stocks that fit your financial objectives and tolerance for risk. For example, you could implement a diversified investment portfolio with dividend-paying stocks, growth stocks and stocks of foreign companies. ETFs require an indirect investment in all the stocks of particular indexes, which could lead to over-diversification and duplication. For example, ETFs that track the S&P 500 index and the technology industry would have several stocks in common.
The return on investment for an individual stock depends mostly on its fundamentals. You can reasonably estimate its long-term return based on certain assumptions about industry and economic conditions. It is more difficult to predict ETF returns because they could depend on the performance of stocks in different industry sectors. For example, if the Dow Jones Industrial Average is down 10 percent, the corresponding ETF will also be down about 10 percent regardless of the performance of individual stocks within the Dow. The index could be down because of the underperformance of a handful of stocks or weakness in one particular industry. There is no opportunity to pick undervalued stocks and wait for the market price to catch up to earnings growth, cash flow and other financial fundamentals.
The cost of owning individual stocks is usually less than owning ETFs or mutual funds. You would pay a one-time commission for buying individual stocks, unless you are trying to time the market and trading more frequently. You would pay similar commissions for buying and selling ETFs. You would also be responsible for management fees and expenses. For example, if the Dow Jones is up 5 percent for the year, the corresponding ETF could be up about 4.75 percent because of a management fee of 0.25 percent. Although these management fees are not as high as actively managed mutual funds, they do affect your return on investment.
- stock market image by Sydney Alvares from Fotolia.com