If there is one thing Wall Street gets right, it’s giving investors choices. One choice that all investors eventually encounter is how to put their money in the market. There are generally two options for the semi-active investor: ETFs and individual stocks.
What’s an ETF?
ETFs are like mutual funds without all of the overhead. When you buy a share of an exchange-traded fund, you own a share of the investment pool the ETF owns. The fund can be indexed to a particular stock index, or actively-managed by an asset manager. For example, the SPY ETF owns all the stocks in the S&P 500 index. Buying SPY is like buying 500 different stocks with one single trade.
When to Use ETFs
Exchange-traded funds are great when an investor wants exposure to a variety of different stocks. Here are a few reasons why you might want to invest in ETFs:
1. Diversification – ETFs can be great for diversification. An ETF like the Market Vectors Gold Miners ETF (GDX) holds 32 different companies that are all involved in gold mining. The Russell 1000 Index Fund (IWB) holds shares of stock in the 1000 largest publicly-traded companies on the stock market. ETFs can be used to buy diversified positions based on industry, geography, or broad indexes.
2. Access – ETFs also give investors the option to invest in markets that are otherwise inaccessible on the stock market. The ETFS Physical Platinum Fund (PPLT) allows investors the opportunity to buy platinum on the stock market. The United States Oil Fund (USO) gives investors a proxy to own oil. And hundreds of bond ETFs make it possible to invest in bonds with a stock brokerage account.
3. Low costs – ETFs charge a small annual expense fee on fund assets. You will also pay commissions to buy and sell an ETF. Many well-known brokerages like TD Ameritrade, Charles Schwab, Fidelity, and others have programs that give investors commission-free ETF trades.
ETFs work best when an investor has some kind of idea about a broad selection of companies. If you think the emerging markets like India will be red hot for growth, you might buy an ETF of Indian stocks. If you think gold prices are going to rise, you might buy a gold miner ETF to capitalize on gold prices.
When it comes to broad ideas that are not company-specific (all gold producers benefit from rising gold prices, and all Indian stocks would do better with better than expected growth in India), an ETF makes the most sense. You don’t need to know much about the individual companies in an industry when you use an exchange-traded fund.
ETFs are limited, however. Investors should read the prospectus for an ETF before making an investment. The prospectus defines how the ETF will be managed, how much it costs to hold the ETF each year, and tax information surrounding any dividends or disbursements to investors.
When to Buy Individual Stocks
Investors always have the option to invest in individual stocks. Buying individual stocks makes the most sense when you have company-specific insight that you think will give you a market-beating return.
Individual stocks offer:
1. More upside potential – When you buy an ETF, you’re limited to the average return for a collection of investments. A single stock investment gives you much more upside potential, but also more downside risk. It is very possible for a tech company to go bankrupt, highly unlikely that the whole industry represented in the Technology SPDR ETF (XLK) to go broke at the same time.
2. More room to add value – Individual stocks provide investors with more opportunity to uncover information not yet priced into the stock. An individual stock investor needs to know about company management, the financials of individual firms, and the company’s competitive standing in the marketplace before making an investment.
Individual stocks have their downsides. Individual stocks are much more costly to trade than ETFs. Whereas hundreds of ETFs can be traded for free, you’ll encounter a commission for every individual stock you buy and sell. For this reason, individual stocks make a good investment only when you have a significant amount of money to invest. If you pay $10 to buy and sell $1,000 of stock, you’re down 2% from the very start. Making up that difference is more difficult than most think, so invest in individual companies only when the commissions make up a very small part of your total investment. A $20 charge to buy and sell stock is much more manageable when you’re investing $10,000 instead of $1,000.