ETFs vs. individual stocks: How to choose

Key differences between ETFs and stocks

ETFs (exchange-traded funds) are a type of investment designed much like mutual funds. They invest in hundreds, sometimes thousands, of individual securities, but they trade on an exchange throughout the day like a stock.

Stocks are securities that represent ownership in an individual company. Each share of stock gives the holder a small stake in the company's assets and earnings.

• Investing in ETFs can be less risky than investing in individual securities.
• You can complement the ETFs in your portfolio with specific stocks and bonds.
• ETFs provide built-in diversification to reduce risk, while individual stocks offer the potential for higher returns but come with greater risk.

Understanding stocks and ETFs

Both stocks and ETFs offer ways to participate in the financial markets, but they differ significantly in structure, risk, and management style, so it's important to know how each works. To trade stocks and ETFs, you need a brokerage account where you can place buy or sell orders during market hours. Both can be traded similarly, allowing for real-time transactions throughout the trading day.

How do stocks work?

When you own stock in a company, you become a shareholder, which gives you certain rights like the ability to vote on key corporate decisions and receive a portion of the company's profits in the form of dividends.

Stock values fluctuate based on company performance, market conditions, and investor sentiment. To trade stocks, you use a brokerage account to buy or sell shares during market hours.

Here's a breakdown of key things to know about investing in stocks:

• Ownership. When you purchase stock, you become a partial owner of the company. The number of shares you own determines your percentage of ownership.
• Dividends. Some companies distribute a portion of their profits to shareholders in the form of dividends, which can provide a source of income.
• Price appreciation. The value of a stock can increase over time due to various factors, including strong company performance, positive market sentiment, and favorable economic conditions. On the other hand, poor performance or negative market conditions can cause the stock price to decline.
• Shareholder rights. Shareholders have the right to vote on important matters, such as electing board members and approving major corporate actions.
• Company performance. The financial health and performance of the company directly affect its stock price. Positive earnings reports, new product launches, and other growth indicators can boost the stock, while negative news or financial setbacks can lead to a drop in price.

How do ETFs work?

ETFs are designed to track the performance of a specific index, sector, or group of assets. They do this by holding a basket of securities that mirrors the composition of the underlying benchmark. For example, an S&P 500 ETF will hold all stocks in the S&P 500 Index in the same proportions.

This diversification helps to spread risk, as the performance of an ETF is not solely dependent on the success or failure of a single company. Instead, it reflects the average performance of the entire group of assets, which can be more stable and less volatile compared to individual stocks.

Much like mutual funds, ETFs are managed by professionals who either actively choose stocks or bonds based on research or passively replicate an index. Most ETFs are passively managed, which often means lower fees.

Buying shares of an ETF is a way to indirectly own the stocks or bonds held by the fund. For example, if you wanted to own stock in a company like Apple, you could buy Apple stock directly. Or you could buy an ETF or a mutual fund that includes Apple stock along with hundreds of other companies.

Different types of ETFs

1. Index ETFs: Aim to replicate the performance of a broad market index, such as the S&P 500 or Dow Jones Industrial Average. They're passively managed and typically have lower fees.
2. Core ETFs: Similar to index ETFs, but they're typically broader in focus and designed to form the foundation of an investment portfolio. They often track major indexes, with the aim of providing balanced and diversified market exposure.
3. Sector ETFs: Focus on specific industries or sectors, like technology, health care, or finance, allowing investors to gain exposure to a particular area of the market without picking individual stocks.
4. Dividend ETFs: Invest in companies that have a history of consistently pay dividends, providing a steady stream of income. They can be an option for investors looking for regular cash flows.
5. Bond ETFs: Hold a variety of bonds, offering broad exposure to fixed income securities. They help balance a portfolio with historically more stable returns and can be suitable for risk-averse investors.
6. Environmental, social, and governance (ESG) ETFs: Designed to invest in companies that meet specific environmental, social, and governance criteria, allowing investors to align their portfolios with ethical values and sustainability goals.
7. Active ETFs: Managed by professionals who make investment decisions based on research and expertise. They aim to outperform a benchmark and may carry higher fees than passive ETFs.

Here's an overview of how ETFs work:

• Trading. ETFs can be bought and sold throughout the trading day, just like individual stocks. This liquidity allows investors to enter and exit positions quickly.
• Fees. ETFs generally have lower management fees compared to similar mutual funds, making them a cost-effective investment option.
• Diversification. ETFs provide built-in diversification, which helps reduce the risk of investing in a single asset.
• Management. Most ETFs are passively managed, meaning they follow a specific index or benchmark rather than being actively managed by a portfolio manager.

Learn more about index vs. actively managed funds

Understanding how ETFs work and the different types available can help you decide which ones align with your investment goals and risk tolerance. To see what we offer, explore Vanguard ETFs.

How to trade stocks and ETFs

To navigate the world of stock and ETF trading, begin with these fundamental steps:

1. Set investment goals. Define what you want to achieve, whether it's long-term growth, income generation, or short-term gains.
2. Choose a brokerage. Select a reputable online broker that suits your needs in terms of fees, platform, and services.
3. Open a trading account. Complete the necessary paperwork and fund your account.
4. Educate yourself. Use reliable sources to learn about the markets, different types of investments, and trading strategies that align with your goals.
5. Place your orders. Execute trades through your brokerage platform, choosing from market, limit, or stop orders.
6. Monitor and rebalance your portfolio. Keep an eye on your investments' performance and rebalance as needed to maintain your desired asset allocation.

You might also consider working with a professional financial advisor for personalized guidance.

Balancing ETFs and individual stocks in your portfolio

ETFs and individual stocks each have their own advantages and can serve different purposes depending on your investment horizon, risk tolerance, and specific interests.

Long-term vs. short-term strategies

For long-term investors, ETFs can be a good choice because of their diversification, lower fees, and broad market exposure. Those with a higher risk tolerance and interest in specific industries might also find individual stocks appealing.

Short-term investors often use individual stocks to capitalize on market movements and company news, which can be more lucrative but also more volatile.

In general, long-term investing can offer a more stable and sustainable path to wealth accumulation, while short-term trading involves higher risk.

Risk considerations

Diversification is key to managing risk. ETFs can help reduce risk by holding multiple securities, making them ideal for risk-averse investors. Individual stocks increase risk but can offer higher returns. Combining both can create a balanced portfolio that aligns with your risk tolerance.

How ETFs and individual stocks work together

ETFs and individual stocks can serve distinct roles within a portfolio. One approach is to use ETFs for broad market exposure and stability, forming the foundation of the portfolio, while adding individual stocks for targeted growth in specific areas. Sector ETFs provide exposure to entire industries, such as technology or health care, while individual stocks let you invest in particular companies within those sectors.  

For geographic diversification, international ETFs offer global market access, and individual foreign stocks can target specific regions or countries. In terms of income generation, bond and dividend ETFs provide a steady stream of income, while high-yield dividend stocks can enhance income with a higher risk profile.

When does investing in individual stocks make sense?

For those with a higher risk tolerance, the potential for significant gains through investing in stocks can outweigh the risk of losses. If you have interest and expertise in specific industries, such as biotechnology or electric vehicles, investing in individual stocks can allow you to capitalize on it.

Active investors who enjoy researching and managing their portfolios can benefit from the hands-on approach that individual stocks offer.

By integrating ETFs and individual stocks, you can create a balanced and diversified investment strategy. For more on stock investing, visit Vanguard's guide to stocks.