Whether you’re new to investing or not, trying to figure out where and how to invest your money can feel overwhelming.
There are so many options, methods, strategies, and ways to build wealth.
All of them are different. All of them will yield different returns for different investors. And all of them have the potential to make your head spin in different ways.
And, with the average person making about 35,000 choices per day, I understand that decision fatigue is the last thing you want to experience.
That’s why I’m here to help.
Types of Investments
Let’s start with a quick and dirty overview of the most popular types of investments.
Portfolios that allow you to pool your money with other investors to “mutually” put it toward individual stocks, bonds, or other investments.
An index fund is similar to a mutual fund in the sense that it is also a portfolio of individual stocks or bonds, but this portfolio follows a benchmark index.
There are some other key differences between index funds and mutual funds, though, so be sure to familiarize yourself with each before you make a decision.
Exchange-traded funds (ETF) are types of index funds that are traded during major stock exchanges.
ETF examples you may have heard of include the SPDR S&P 500, which tracks the S&P 500 Index, and the Invesco QQQ, which tracks the Nasdaq 100 Index.
Stocks are simply shares of public companies that can be traded among buyers and sellers.
That’s it. Nothing more.
At Rule #1 Investing, we like to think of stocks as investments in wonderful companies. You can keep this in mind as we continue to discuss all of the options available to you.
Which Investment is the Right Investment?
When it comes to investing, there is no “right option.” Only the option that is right for you. Just because these investing methods are popular, doesn’t mean you need to try them all. Be smart.
Put your money in places that give your wallet the most return and fit your lifestyle accordingly. And most importantly, develop an investment strategy that will help you reduce your risks and grow your wealth.
To put you on the path to achieving this goal, we’re going to dive into the two investment options most likely to help you get there: ETFs and stocks.
ETFs vs Stocks
An ETF will provide you with a different type of investment than stocks will. Before you make a decision about the option that is right for you, let’s dive into more of the details associated with— and differences between—these investment types.
What is an ETF?
As mentioned above, an exchange-traded fund (ETF) is a type of professionally managed and pooled investment that consists of a collection of individual stocks, bonds, or other investments.
Essentially, when you buy a share of an ETF, you buy fractional shares of the pool of investments. This type of small investment could be a fit for you if you want to begin creating future wealth without breaking the bank.
There are a number of ETF types you can choose from, which include:
This ETF type tracks exactly what it sounds like—stock. Within this ETF category, you can choose among ETFs covering different business sizes, stocks from a specific country, or even stocks from a sector experiencing large amounts of growth, like perhaps the tech sector, for example.
Investors who are interested in diversification will often gravitate toward bond (or fixed income) ETFs. Generally speaking, it is often thought that these ETF types provide a better return at a lower risk than equity ETFs.
Commodity ETFs are focused on oil, gold, and silver. Though they sound like an appealing option, it is important to keep in mind that these ETFs usually don’t own the asset it is assigned to.
Instead, they use derivatives to track the price of the commodity, therefore making this ETF type a riskier investment than some of the others.
Currency ETFs are investments in different kinds of legal tender, such as the U.S. dollar or the euro. These portfolios can include multiple currencies and can use a mix of direct investments and derivatives.
In many cases, currency ETFs are designed to protect or hedge your investment portfolio.
Specialty ETFs, like leveraged funds and inverse funds, provide greater growth potential at a higher risk.
Unless you have done extensive research on the investments you wish to make, I recommend focusing on the other ETF options available.
Factor ETFs focus on characteristics that can help to better explain possible investing risks and returns. These ETFs can be extremely beneficial as they can give you a better sense of exactly how much income you could generate and how you could manage and oversee any potential risks to your portfolio.
Sustainable ETFs use environmental, social, and government data to grow wealth through traditional investing methods. This type of ETF is fairly new but is becoming more widely accepted as ideologies on demographics and political policies continue to shift.
Each of these ETF types has its pros and cons, but the most important thing to remember is that building an ETF portfolio that contains a few different ETFs will help you fine-tune your overall investment strategy.
ETFs in the Market
Exchange-traded funds function differently in the market than stocks do. Whereas individual stocks focus on one firm, ETFs provide broader exposure to a number of markets.
ETF investment strategies are diverse. Some ETFs track the results of specific indexes such as the S&P 500, for example. While others abide by the principles outlined in certain investment strategies, like growth or value investing. And others still, focus on business sectors of specific interest, such as technology or energy.
A popular misconception about ETFs is that they are not worth investing in because the return is not the same as it would be on an individual stock. This is not necessarily true.
If you are able to help an investment achieve alpha—or the place where it begins to outperform its benchmark—you will earn a higher return on that investment.
Depending on the sectors of the different ETFs that you invest in, alpha is achievable and is the second-best investment option from stocks for any beginner investor.
Key Differences: ETFs vs Stocks
We’ve covered a lot of information about ETFs up until this point. But what about ETFs vs stocks?
Here are some of the key differences between exchange-traded funds and stocks that you can use to make the best investment decision for you.
Exchange-traded funds are a professionally managed and pooled type of investment. This makes them less risky because you are not the sole investor and you are also not investing in one single businesses’ success to provide you with a good return.
A slight downside is that ETFs are less liquid, making them less readily available to be converted to cash.
Stocks, on the other hand, are an individual share of a company. Therefore, they can be riskier because they are tied to the performance of a single business. They can also be slightly more liquid, depending on the type of stock.
In general, investing in ETFs vs stocks comes down to the amount of involvement you want in your investments.
As a stock investor, you’ll need to have a good understanding of how to invest in stocks. In other words, you will need to do more upfront individual research and base your decisions on your findings.
Whereas, if you find ETF investment strategies are a better fit for the financial future you wish to create, ETFs are professionally managed. Therefore, all the research, buying, and selling of stocks will be done for you.
Similarities of ETFs & Stocks
On the flip side, the similarities between exchange-traded funds and stocks are also plenty. Both investments:
- Are commonly referred to as “assets” and “securities.” This can sometimes make it challenging to identify which investment option is being discussed.
- Are trades on an exchange. This means that during a trading day, both ETF and stock values could fluctuate. In addition, they also both provide high liquidity and transparency when it comes to your investment.
- Provide a range of options. Each of the ETF examples discussed earlier provides a different benefit to the investor as do the variety of stock options that are available.
- Support a variety of order types. Market order dictates the way you can buy or sell assets for the best price.
- Can use options or sell short. Having stock options is great and this applies whether you are investing in ETFs or stocks. This provides you with more flexibility in terms of the date of the transaction and the price point of your investment. In addition, both investments allow you the opportunity to sell short, meaning you can borrow shares you don’t own and sell them to another investor.
- Pay dividends. With either option, funds will be paid equally to shareholders.
Pros and Cons of ETFs
In the eyes of many, ETFs are predicted to surpass mutual fund assets in the U.S. Their rapid growth puts them in the perfect position to become the future investment of choice.
However, if you’re thinking about adding some ETF investment strategies to your overall investment portfolio, here are some of the pros and cons of ETFs that you may want to consider before diving in.
Advantages of ETFs
- Increased liquidity. This level of liquidity allows investors to sell their holdings without difficulty, which can easily lead to substantial financial gains.
- Reduced volatility. The odds of an ETF changing rapidly and drastically is fairly low. Different ETF examples will yield different outcomes, however. Generally speaking, an ETF that tracks a broad market index, like the SPDR S&P 500, will be less volatile than an ETF that tracks a specific sector or industry.
- Ability to be sold through market orders. Investors can trade ETFs as if they were stocks.
- Diversity. There are a number of ways that you can get involved with investing in ETFs. The variety in the available options is limitless. Be sure to do your research when building an ETF portfolio so that you are getting the most out of your chosen investments.
- ETF tax efficiency. In many cases, ETFs can be more tax-efficient than a traditional mutual fund. ETF tax efficiency stems from the way ETFs are structured. Typically, taxes are minimized for the ETF holder and the overall tax bill will be less than what you would’ve paid through a similar mutual fund. However, dividends and interest payments are still required to be paid on ETFs.
Disadvantages of ETFs
But, just as ETFs offer a number of benefits, I’d be remiss in not mentioning some of their drawbacks, which include:
- Fees and commissions. In many cases, the fees on ETFs are higher than other investment options. Each time you buy or sell an ETF, you will usually pay some type of commission. In terms of the amount, fees on ETFs can vary but are generally no higher than $20.
- Limited diversification. Although this may not seem like a con for us Rulers, as we like to take Warren Buffett’s advice that, “Diversification is protection against ignorance,” it still limits your ability to grow wealth by investing varying amounts of money in wonderful companies.
- The unknown index factor. When you buy fractional shares, as you do with index investing, the index is only going to increase as much as the average of the stocks within the index. This is limiting because it caps the amount of growth potential. However, when you invest in a wonderful company that has been vetted based on the 4 M’s–meaning, moat, management, and margin of safety–there is room to experience more financial gain.
- Overlooking the success of wonderful companies. When you purchase an ETF, you’re betting on the average stock price of the entire index or industry, so you’re not gaining anything from the potential returns of investing in the great companies that significantly outperform their competitors. Plus, leveraged ETFs in particular, can be a high-reward or high-risk investment. You could end up either doubling or tripling the returns of a stock market index or doubling or tripling your losses.
When to Invest in ETFs vs Stocks
This brings us to the final question in our ETFs vs stocks debate which involves when to invest in ETFs instead of stocks. Let me break this down for you.
Consider ETFs When…
- …you’re unclear on how a company will perform. If you do not have a good understanding of the factors that are driving a businesses’ success, an ETF will be your best bet. ETF companies might have complex technology or processes that can cause them to perform very well or extremely poorly. Because of this, your chance of returns is variable and the odds are good that you could find an ETF that will give you the return you’re seeking.
- …you want to invest in a specific industry. ETFs can be a better investment option depending on what exactly it is you want to invest in. As always, be sure to do your research and know all of your options before deciding how and when to invest.
And time also plays an equal factor in both types of investments. If you’re wondering how long to hold an ETF vs stock, the answer will vary greatly depending on your investment strategy.
If you’re saving for something in the long term, like retirement, you’ll want to hold on to the ETF for as long as you can because the longer you hold onto it, the more interest you will accrue on your asset.
Invest in Wonderful Companies to Grow Your Wealth
The bottom line is this: If you want to have the freedom to rest assured that your investments are building generational wealth and are continuing to grow with each passing day, you must invest in wonderful companies.
This is one of the core beliefs of Rule #1.
As a Rule #1 Investor, we believe that you really aren’t investing in stocks, you’re investing in wonderful businesses at attractive prices to generate consistent returns. It’s as simple as that.
You don’t need to be an expert to invest like one. We only ask that you follow the tried and true rule used by all of the best investors in the world: don’t lose money.
By abiding by this principle, you can begin investing with certainty and start building a path toward a brighter financial future. Learn more about how to start investing using the proven Rule #1 strategies.
And, if you want more investing information on how to find stocks to invest in, download The 4Ms Guide
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.