Exchange-traded funds (ETFs) offer the diversification and professional management benefits of mutual funds, while retaining some of the advantages of individual stocks. On the other hand, ETF investors may make good money, but they don't have an active role in stock selection, nor the chance to experience the thrill of picking a winning stock themselves. A good investment compromise may be to invest in some individual stocks, but to have a larger stake in ETFs.
Individual Stock Basics
When you own an individual stock, you own a piece of one company. It's up to you to decide which companies you want to invest in, and you're the one who determines when's the right time to buy, sell or hold. If you have a keen investment sense, and do your homework, you might be a successful stock picker. Some stock investors get a rush from picking a good stock, the way a gambler does when he hits a jackpot. If this describes you, then you probably want to pick at least a few individual stocks, and see how it goes.
ETFs are investments comprised of a basket of stocks that trade like regular shares. The original ETFs mirrored one of the stock exchanges, like the NASDAQ or the Dow Jones Industrial Average. Nowadays there are ETFs that invest in a wide variety of market sectors, in addition to those that are linked to an exchange. They're similar to mutual funds, in that their shareholders have a fractional ownership in a set of stocks. Mutual funds, however, are valued just once a day, at the market close. ETFs actively trade throughout the day, and can be bought on margin or sold short, just like individual stocks. There are also ETFs that invest in bonds and commodities.
Pros and Cons of Individual Stocks
Since individual stocks are self-managed, you incur no management fees, but they are subject to brokerage fees when you buy or sell. It's possible to lower fees by purchasing stock directly from the company, in cases where direct investment plans are available. Even direct investment plans charge for transactions. An individual stock winner can yield great rewards, but it's difficult for small, individual investors to have a diversified investment portfolio made up solely of individual stocks. Your fortunes ride on a small number of companies, and if they fail, so do you. To be a successful individual stock investor, you need to keep well informed and monitor your choices closely. However, you may find that you don't want to spend that kind of time managing your money.
Pros and Cons of ETFs
ETFs charge commissions and brokerage fees, but generally they have low management costs and expense ratios. Many funds have low turnover, and are structured in a way that makes them tax-efficient. They're popular with investors looking to minimize their exposure to capital gains distributions. Like individual stocks, you pay capital gains when you sell your shares. This fact makes ETFs appropriate for investors who like the concept of mutual funds, but who want to avoid the taxes associated with distributions that mutual funds have each year. Like mutual funds, ETFs offer diversification because they invest in a large number of different companies. Even if a few companies fail, there are probably others in the portfolio that perform better, and can ease the pain.
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