Stocks are the most commonly traded instrument on major financial exchanges, hence the name “stock” exchange. However, there is another commonly traded investment instrument called Exchange Traded Fund (ETF), which has grown greatly in popularity among traders and investors.
While exchange traded funds vs stocks share many common features and are both considered most-traded securities, there are key differences between the two.
What is a stock
Publicly traded companies are divided into shares, commonly known as stocks, which are freely traded on stock exchanges. These individual stocks represent a percentage of ownership in a company, ranging anywhere from 100 per cent to barely above 0 per cent.
When trading in stocks there is a buyer and seller. The price is based on what these two parties agree the stock is worth. At any given time, the price of a particular stock is based on supply and demand. The greater the supply of sellers on the market the less the stock will be worth and the more buyers there are the higher the price will go.
This is a simplistic explanation of stock price but it is the underlying principle behind all stock market valuation as the total value of all the shares in a company does not necessarily represent the actual value but the perceived value of the company.
Shares in a corporation can be broadly divided into two main types, common and preferred stock. Common stock entitles the owner to voting rights in the company regarding corporate decisions equal to their ownership percentage and the possibility of receiving dividends. Owners of preferred stock do not have voting rights but do have the right to be paid dividends before the owners of common stock.
What is an ETF
An Exchange Traded Fund is an investment instrument comprised of a basket of securities such as stocks, bonds, commodities, currencies or indices within an exchange.
Trading ETFs vs stocks is very similar as both can typically be sold short, bought on margin, and offer options. ETFs share some common features with mutual funds – they both are made up of a diversified basket of securities – but do not typically require a minimum investment like most mutual funds.
An exchange-traded fund is a marketable security with an associated price that can be easily bought or sold. ETFs usually offer lower expense ratios and broker fees, than investing in individual stocks.
Comparing investor shares vs ETFs, you should note that ETFs will almost always carry much higher transaction fees. On the other side if the investor is looking for a long-term investment and does not have the time or desire to be actively trading, they may find exchange traded funds to be a lower cost option.
Stock vs ETF
The difference between stocks and ETFs can be compared to picking an item off the menu at a new restaurant or going to the buffet. Choosing a single item does present the possibility of finding a new favourite dish (high return) but there is also the potential that you will not like what you ordered (high loss).
An ETF is similar to the buffet in that you are getting a little taste of many different items (securities) and the risk of not liking one (loss) does not have the same consequences as it is only a small piece of the overall order.
The gold market is another good example. Many people are aware that gold mining is a high risk/high return industry. Investing in a single gold-mining company could yield high returns if they locate a rich strike but also the risk that they come up empty handed. An ETF focused on the gold sector will be invested in many different gold operations and by doing so should provide a reasonable return even if a few of the investments take a loss.
Overall ETFs can provide an investor with broad diversification in the market for a low cost and with relatively little specialised knowledge. While ETFs are designed and managed by experts, experienced investors may be more inclined to diversify their portfolio by choosing stocks which meet their individual risk preference in the hopes of higher returns.
These same investors may also see the value in ETFs when investing in higher risk sectors such as emerging markets or commodities. The decision to purchase stock or ETF, will be based on the individual investor preferences. It is important to note that buying ETFs does not preclude you from investing in individual stocks and for many people a mix of the two will be the most applicable.