Why Investing in ETFs Is a Better Strategy Than Picking Individual Stocks, According to Experts

7 months, 1 week ago - February 21, 2022
Why Investing in ETFs Is a Better Strategy Than Picking Individual Stocks, According to Experts
Why buy one stock when you can buy them all?

That’s what you get with an ETF or an exchange-traded fund. They’re often referred to interchangeably as index funds — and compared to stocks, they’re among the most commonly heard-about options for beginner investors, and remain the best choice when compared to buying individual stocks.

New investors, while excited to learn, can all too easily fall prey to beginner investing mistakes like analysis paralysis when trying to weigh the pros and cons of each investment vehicle. Meanwhile, you might hear conflicting advice about which stocks are too risky and which ones are “sure things” (even though there’s no such thing in the stock market).

Of course, it’s important to be informed, but in truth the best time to start investing is today. So let’s talk about whether you should invest in stocks or ETFs. Once you break it down, you’ll see that experts recommend ETFs over stocks in almost all situations.

Stocks vs. ETFs — What’s the Difference?

Stocks give shareholders a piece of a company. They’re also known as ‘“equities.” The more shares you purchase, the more you’re expressing ownership of a company. If the company loses money, so do you (because the value of your stock goes down). Many companies, but not all, offer dividends, or payment a company makes to shareholders.

“The biggest difference is that when you’re looking at a single stock, you’re buying into a singular company,” explains Lori Gross, financial and investment advisor at Outlook Financial Center. For example, if you own shares in Apple, your gains and losses are driven solely by Apple’s performance. Owning individual stocks is risky because your investments are pinned to a single company’s future performance.

ETFs on the other hand contain hundreds, if not thousands, of stocks from companies in various sectors and industries. “When you buy an ETF, you’re looking at a basket of stocks,” says Gross. For long-term investing, ETFs are generally considered safer investments because of their broad diversification. Diversification protects your portfolio from any one single downturn in the market since you’re money is spread out among these hundreds, or thousands, of stocks.

You can purchase ETFs in the same way you purchase stocks. Like stocks, you can buy and sell ETFs throughout the day.

In addition, most ETFs are passively managed by algorithms that track an underlying index, such as the S&P 500, total market, or a specific section of the market. Underlying fees are therefore much lower for ETFs than actively managed accounts.

Last, ETFs seek to match an index — not outperform it. Whereas individual stock prices can fluctuate by huge margins, ETFs will generally move less dramatically. Returns from ETFs therefore tend to be less dramatic, but steadier over a long period of time.

When Stocks Are Better

Stocks have the potential to bring investors better returns than ETFs — but they rarely do. Unlike ETF investing, the act of buying and selling stocks is an ongoing dance with multiple factors, including timing, market sentiment, industry news, environmental and economic factors that could all influence the price of shares.

Not to mention, human emotion contributes to the unpredictability of stocks. Even trained finance professionals who devote their entire careers to choosing the best stocks to invest in struggle to outperform an S&P 500 index fund. Actively managed large-cap funds underperform the S&P 500 nearly 83% of the time, according to S&P Dow Jones Indices, which provides data from the S&P 500 and the Dow Jones. That means that only 17% of these funds beat an S&P 500 index fund. Evidence from Morningstar suggests that actively managed funds may be starting to catch up, but the average person likely doesn’t have the time, expertise, and risk tolerance to spend their days keeping up with the news cycle and trading stocks.

“You have the potential to lose every penny you have,” says Don McDonald, host of the podcast Talking Real Money. Some experts therefore compare individual stock investing to gambling in Las Vegas.

You’ll want to be comfortable and make sure you understand the individual stocks you buy, says Gross.

When ETFs Are Better

For long-term investing, ETFs are better “100% of the time, as long as you’re using low-cost passively-managed ETFs that track an index,” says McDonald. “If you own an ETF, you eliminate the risk of total loss.”

That’s not to say that ETFs don’t involve any research at all. You can’t choose which companies are part of an index fund, but you can choose an index fund that most closely matches your goals. ETFs can be grouped by industry, such as tech or healthcare, company size, or exchanges. Socially-responsible investors may also appreciate the option of investing in an ESG ETF, a fund composed of companies pledging to improve their environmental, social, and/or governance (ESG) outcomes. There are a variety of funds available that track a variety of indices, which provides some level of customization to your portfolio.

Does One Have a Higher Return Than the Other?

ETFs are designed to match the performance of an index, meaning ETF investors never outperform the index. Individual stocks, on the other hand, have the potential to take off and earn outsized returns on your investment.

But again — it’s next to impossible to predict which stocks will go up over time. In hindsight, it’s easy to try and look for what company will become the next Amazon or Apple stock, but only time will tell. As they say in the finance industry, past returns are not a guarantee of future performance.

In general, it’s hard to know how an individual stock will perform in the future. But the average S&P 500 index performance has averaged an annual rate of return of 10% for most of the last century.

With any investment, watch out for hidden fees and calculate the expense ratios. Make sure they’re low — under 1% — so they won’t eat into your returns.

Diversifying and Mixing In Both Stocks and ETFs

A burgeoning school of thought says to diversify by investing in both passive investment vehicles like ETFs and actively managed securities like stocks.

If you’re willing to put in the time to research and understand individual stocks, you can make the right investment decisions for your specific risk tolerance and timeline.

If you’re not sure where to begin, choosing an index fund or ETF is a fine place to start for long-term retirement planning, advises McDonald.

You can then mix in individual stocks that look attractive to you as you learn more about how much risk you’re willing to take on. Stocks shouldn’t be the bulk of your portfolio, advise experts.

“If you don’t know what the end game is, it’s hard to invest,” says Gross. Clarity is essential when planning for your financial future.

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