Stock vs ETF: Which is Better for Investments?

What is stock?

When a publicly listed company wishes to raise funds for its venture, it issues stocks, also known as shares, on stock exchanges such as the Bombay Stock Exchange. Depending on how many individual stocks you own, you have a certain percentage of ownership in that company. Also, if you buy preferred stock, then you are not eligible to vote in the company’s decisions but get preference over those holding common stock when it comes to receiving dividends of the company’s profits. There are thousands of listed companies on the market in whose stock you can invest.

Types of stocks

Stocks are of two types- common stock and preferred stock.  While both represent ownership of a company, there are some differences between the two. In this article, we will look at the difference between common stock and preferred stock.

1. Common stocks

When you purchase common stock, you get partial ownership of the company. Common shares also come with the legal right to elect the board of directors. Hence, they also have control over corporate policy and management decisions of a company.

When a company fails, the common stockholders have the lowest priority when it comes to getting back any of their money. Creditors who have lent money to the company get paid back with top priority. Even if some money is left after paying the creditors, the holders of preferred stocks get paid next. This is subject to a maximum amount. Only if money is left even after that, common stockholders get paid.

2. Preferred stocks

One difference between common stocks and preferred stocks is that preferred stocks do not have voting rights.

There are two main reasons why these stocks are called preferred stocks. Holders of preferred shares receive regular dividends which are higher than those received by holders of common stocks. Preferred stocks pay dividends which are agreed upon beforehand unlike common stocks which pay dividends based on how profitable the company is. A company has to pay dividends to its preferred stockholders before it pays any dividend to its common stockholders. When it comes to risk, a preferred stock is riskier than a bond but less risky than a common stock.

Preferred stocks can be of a few types. In the case of convertible preferred shares, you have the option to convert a preferred stock into a common stock. Preferred stocks may also be cumulative. This means that the company may postpone dividend payments when it is not performing well. But when the situation improves, they have to pay the dividends in arrears. This has to be done before any payment is made to common stockholders. Another type is a redeemable preferred stock where the company has the right to redeem the stock at a date in the future.

Pros and Cons of Investing in Stocks

Advantages of Stocks:

1. Potential for Attractive Returns Over Time: Historically, stocks have proven to offer considerable returns over extended periods. For instance, if you were to invest ₹5,00,000 in stocks, and they yield a 10% annual return, after a year, your investment could be close to ₹5,50,000. This illustrates the potential for passive wealth growth through investing in stocks. However, it’s crucial to stress the significance of conducting comprehensive research and analysis before committing to any investment decisions.
2. Benefit of Dividend Earnings: Holding shares in a company may entitle you to receive dividends. These dividends not only provide extra income annually but also enhance your overall investment returns, making stocks an attractive avenue for wealth accumulation.
3. Portfolio Diversification: Stocks offer the benefit of diversification by allowing you to invest in various industries and companies. A diversified stock portfolio can help mitigate the impact of poor performance by any single company. If one stock underperforms, gains from others can offset losses, enhancing stability.
4. Ownership Rights: Investing in stocks grants you ownership in the respective companies. This ownership includes voting rights on important company matters that influence its future direction.

Disadvantages of Stocks:

1. Market Volatility: The stock market is known for its significant volatility, which means that even if you have a long-term investment horizon, you might experience substantial fluctuations in your investment’s value. These price swings can lead to uncertainty and anxiety, especially if you need to access your investments during turbulent market conditions.
2. Information Hurdles: The process of gathering precise and dependable details about individual companies can be quite intricate. Inadequate or incorrect information can result in wrong investment choices, increasing the likelihood of financial setbacks for investors.
3. Asset Liquidation: Stocks are generally fairly liquid, meaning they can be readily bought and sold. However, during market downturns or periods of panic, concerns regarding liquidity may arise. In these situations, locating willing buyers for your stocks can pose a challenge, potentially impeding your ability to sell your investments promptly. Liquidity concerns can become especially troublesome if you find yourself in need of swift access to your invested capital.

What is ETF?

While stocks are just one instrument, an ETF is a basket of securities consisting of diversified investments such as stocks, commodities, bonds, and other securities. These funds are called holdings. The shares to these holdings are then sold to investors by the fund manager. In India, ETFs first arrived on the investment scene in 2001. Today, there are several ETFs in India from which to choose.

Pros and Cons of Investing in ETFs

Advantages of Exchange Traded Funds

1. Diversification: A single ETF can provide exposure to various stocks, market sectors, or styles, allowing for a well-rounded investment portfolio.
2. Liquidity: ETFs can be traded throughout the trading day, providing flexibility, especially during times of high market volatility.
3. Lower Costs: ETFs are passively managed, resulting in significantly lower cost ratios compared to actively managed mutual funds. This means reduced management fees, shareholder accounting expenses, and other service fees.
4. Low Tracking Error: Tracking error is the difference between the returns by the ETFs and the underlying index, say NIFTY 50. For example, if the daily return of NIFTY 50 was 0.5%. Consequently, the return of NIFTY 50 ETF should also lie in the same range. A tracking error of up to 2% is acceptable for an ETF.

Disadvantages of Exchange Traded Funds (ETFs)

1. Limited Diversification: Some ETFs may have limited exposure due to the number of securities in the underlying index, potentially missing out on growth opportunities in small-cap companies.
2. Intraday Pricing Volatility: ETFs are traded in real time on exchanges. This causes volatile returns over a period of time. This may hamper the investing strategy of low-risk investors. It is highly advisable to evaluate your risk appetite before investing in any ETF.
3. Lower Dividend Yields: While dividend-paying ETFs exist, their yields may not match those of individual high-yielding stocks.

Exchange-traded funds (ETFs) offer a range of advantages and disadvantages for investors. They are widely used for portfolio diversification and industry exposure, but it’s essential to consider these factors before investing to make informed decisions.

Other Types of ETF

Usually an ETF is meant to make money as the value of the fund increases, that is, when the market or at least the set of stocks that the fund has invested in is bullish. However there is another type of ETF that acts as the exact opposite. It is called an Inverse ETF.

What is an Inverse ETF?

This type of ETF benefits when the status of the index it tracks falls, as the name implies. It is made up of derivatives including futures contracts, options, and swaps, among others. A ‘short ETF’ or ‘bear ETF’ is another name for an inverse ETF. When a market undergoes price drops, it is referred to as a “bear” market.

Inverse ETFs typically invest in daily futures. When the index falls by 2%, the inverse ETF climbs by 2%. An inverse ETF is a short-term investment because it is based on derivatives such as futures contracts, which are exchanged daily.

What Are Leveraged Inverse ETFs?

Aside from derivatives, debt can be used to boost the index’s results. Returns can be boosted by a factor of 2:1 or even 3:1 with a leveraged inverse ETF. This reflects that if the NIFTY 50 from the previous example falls 3%, your 3x leveraged inverse ETF will rise 9%.

Advantages Of Inverse ETF

In your investment portfolio, it functions as a contrast to standard ETFs. If you have standard ETFs tracking a benchmark index, having an inverse ETF tracking the same index means that if the index loses points, your inverse ETF compensates for it and more.

Disadvantages Of Inverse ETF

The first drawback stems from the high expenditure ratios. Because inverse ETFs are actively managed funds, this is the case. However, you will be better rewarded if you own inverse ETFs for a short period of time. In the long run, shorting stocks or index funds is a superior option.

Similarities ETF and Stocks

Before you consider the points for stock vs ETF, remember that they hold significant similarities.

1. Both are taxable
2. Provide an income stream
3. Offer hundreds of options
4. Can be bought on a margin and sold short
5. Both can be traded on the stock market throughout the trading day.

Differences between stocks and ETFs:

1. Investing in an ETF is associated with lower risk as it is diversified. You are investing in a portfolio of different entities, and it is unlikely that all of them will lose their value. On the other hand, investing in individual stocks can be riskier, especially if you put all your eggs in one basket. If the company loses its value, then your stock’s value falls, and there is no other investment instrument to nullify that loss.
2. ETFs require a professional to manage the investment for you, whereas investing in stocks doesn’t necessarily need a broker. You can do your research and build a robust portfolio.
3. An ETF has a higher transaction fee compared to when you buy individual stocks. However, the expense ratio and broker fees are usually lower for ETFs.
4. Your ETF is managed by a professional saving you the trouble of deciding which portions of the ETF to sell or hold. In the case of individual stocks, you will need to keep an eye on the market to know when to buy, sell, or hold. Inversely, in the case of ETFs, you do not have control over what happens to the portions of your ETFs; while in stocks, you have control over what stock selection.

Stocks or ETFs – Which is Better for you?

The choice between investing in ETFs or individual stocks depends upon one’s investment approach. Opting for individual stocks is most suitable for investors who seek the flexibility to actively construct and manage their portfolios. Investing in stocks requires a good understanding of the overall market and economy. These investors are comfortable taking on the risks associated with trading individual stocks in pursuit of potential returns.

Conversely, ETFs can prove to be the optimal selection for both novice investors and seasoned ones with limited time to consistently monitor the stock market. ETFs represent professionally managed portfolios that enable investors to diversify their investments across various ETF categories, simplifying the process of building an investment portfolio.

Many investors prefer a blended approach, incorporating both ETFs and individual stocks into their portfolios, recognising the unique advantages each offers. The key lies in comprehending the commonalities and disparities between the two and how they align with the investor’s strategic objectives. It’s essential to acknowledge that there is no definitive right or wrong choice in the realm of investing; rather, the decision hinges on selecting the appropriate stocks or funds based on one’s financial goals, investment horizon, and risk tolerance.

Conclusion

Just like any other important aspect of your life, investing also depends on your research, personal preferences, and the guidance of someone experienced. You will have to put in a reasonable amount of effort to identify your financial goals and understand your appetite for risk. For professional guidance, take the help of an advisor or broker to help you choose the best investment options to secure your future.

FAQs

Stocks vs ETF: What is the difference?

Stocks are shares of a single company and they represent a partial ownership interest in the company’s profit and loss. ETFs are pooled funds invested in a bundle of securities and assets, such as stocks, bonds, or commodities.

Which one offers better diversification: stocks or ETFs?

ETFs generally offer better diversification than individual stocks. ETFs invest in a basket of  securities, providing exposure to multiple companies or assets.

Are stocks or ETFs more suitable for active trading?

For active traders, stocks are more suitable due to their potential for greater volatility. Also, they allow traders to target specific company stocks better. ETFs are a type of passive investment that offers exposure to a diversified portfolio.

Which one is more cost-effective: stocks or ETFs?

The cost of investing is the primary difference between ETFs and stocks. ETFs tend to have lower expense ratios, making them more cost-effective than other options like mutual funds. However, if you consider trading costs, stocks have lower transaction fees. ETFs may incur brokerage commissions, which may eventually lower your returns. 

Stocks vs ETFs: Which is better for liquidity?

Both stocks and ETFs have higher liquidity compared to other investments. However, stocks are slightly more liquid than ETFs because of their significant trading volume. The liquidity of an ETF fund depends on the specific fund and the underlying asset.