If you’re investing money, you have probably explored the world of stocks, which are a very common way to build wealth. Typically when people mention investing and building wealth, they are referring to the stock market. While stocks have been around for many decades, other instruments offer investors ways to deploy capital into the stock market such as mutual funds and ETFs. To properly navigate the investment world, investors need answers to important questions such as how is an ETF different from a stock? How do you buy ETFs? What kind of ETFs make sense to own?
Your choices in stock investments are quite diverse, with companies of all sizes in various industries offering shares. You can invest in lower risk, established companies for steady, reliable gains. Or you can turn to higher risk, newer companies for potentially higher gains. You can choose to put your money toward any number of sectors – technology, retail, energy and finance, to name a few.
It is important to understand how stocks work, as well as the different investment choices that are connected to them, like Exchange-Traded Funds (ETFs). ETFs are funds that include a number of securities like stocks, bonds or commodities. They can follow indexes focused on a sector or even a foreign country.
As you’ll learn below, ETFs are very similar to stocks and offer a great way for investors to easily diversify their portfolio. But there are some key differences between buying ETFs and individual stocks, as well as costs to consider.
How do stocks work?
When you buy stock, or shares of a company, you are essentially buying a small piece of that company. You become one of its many owners, so you can profit when the company does or take losses if it underperforms. As the company grows, your portfolio can grow, too.
The price of a share varies significantly from company to company. It’s driven in part by a company’s performance. The price you pay is its market value – or how investors perceive its value. If there is more demand for shares, their price increases. If there is less demand, share prices fall.
A stock’s price is also a result of how the company divided its shares. A company may offer a smaller number of shares for higher prices, or a larger number of shares for a lower price per share. No matter how the company divides its shares, it will still have the same “market cap” or total valuation. So, you can buy stock for pennies or for thousands of dollars per share.
Investors buy stocks through exchanges like E*Trade, which are basically marketplaces to buy and sell shares. They can choose which stock to buy and how many shares. They can even buy the stock immediately at market value or set a trigger point for a purchase.
Most exchanges charge a fees for each trade, however increasingly exchanges are starting to offer trades for free.
How is an ETF different from a stock?
An exchange-traded fund (ETF) trades in the same way as a stock, but it has some key differences. A share of an ETF represents ownership in a fund that holds several stocks or bonds, not ownership in one company like you get with a stock.
As an investment fund, investors essentially pool their money to buy into several assets when they buy an ETF. This way, you have exposure to several assets at once and can easily add diversity to your portfolio.
Like with stocks, investors have a wide variety of ETFs to choose from. Some ETFs follow an index so that your investments’ can mirror its trends. For example, you can buy into an index that follows the S&P 500 or the Nasdaq without having to buy stocks from each of the companies individually. Other ETFs follow sectors or even countries.
The price per share of an ETF also varies widely. It depends on both the value of the assets in the fund as well as how shares are divided.
How do you buy an ETF?
Buying an ETF is easy. Like stocks, they are bought and sold during market hours over exchanges like E*Trade, TD Ameritrade, and Charles Schwab, among many others. Investors can also put advance orders in outside of market hours.
You have broad choices in exchanges. Each exchange has its own fee for trades and offers it own unique tools to investors. So, it pays to shop around for the exchange that fits your needs. You can open an account in about 10 minutes online.
Then, you will need to fund your account to purchase your shares of an ETF. Many investors use the “lump sum” method of buying assets. That means you allocate a particular amount of money to put toward an investment, and then by as many shares as that lump sum allows. For example, if you wanted to put $5,000 toward an ETF offering shares for $25, you would buy 200 shares (5,000 divided by 25).
5 common types of ETFs
ETFs can hold a number of different investment types. Certain types of ETFs are considered riskier than others. Here are a few of the more popular categories:
- Stock ETFs: Comprised of several stocks, stock ETFs are generally considered less risky than buying only one stock. However, they may carry more risk than other types of ETFs.
- Bond ETFs: Bond ETFs are considered one of the lower-risk ETFs as bonds are among the fairly low-risk investment types. Bonds have a maturity, or end point, but bond ETFs do not. You can hold a share of a bond ETF for as long as you like.
- Commodity ETFs: Commodity ETFs hold raw goods, or commodities, like gold, oil or agricultural goods. Commodity ETFs have varying degrees of risk, depending on the underlying commodity.
- Sector ETFs: Many investors like to focus on a sector, or area of the market. Sector ETFs hold companies that operate in a specific sector, such as retail, health care or finance. In the U.S. there are 11 recognized sectors.
- International ETFs: Global stocks can offer investors a way to add international diversity to a portfolio that is heavy on U.S. securities. Investing in foreign stocks through an ETF is considered less risky than investing in foreign securities directly.
What affects the price of a stock?
Many factors can trigger a rise or fall in stock prices, including both broader economic conditions and company-specific events.
How investors expect the economy to perform has a great impact on the price of stocks. If investors expect the broader economy to struggle, they will also expect individual companies to struggle as a result. For example, they may not expect retailers to fare well if consumers are not spending. So, if investors anticipate poor performance ahead, they may start to sell stocks to avoid losses. That trend lowers the share price.
A company’s own performance also affects the price of a stock. A stock may move significantly up or down just after its quarterly reports are released. If its revenue and profits were above Wall Street’s expectations, the price would like increase – and vice versa.
Company-specific news outside of earnings reports can also trigger stock price movements. For example, a CEO’s departure may cause a stock price drop if investors fear uncertainty with the company’s leadership. Or, a sickness outbreak on a cruise ship can also cause that company’s stock to fall if people expect demand for cruise tickets to suffer. Whenever a company announces it will be acquired, it’s shares typically surge.
So, as we further consider how is an ETF different from a stock, it’s worth noting that fluctuations in a stock price also affect the ETF price that might be holding such stocks. For ETFs that hold stocks, the price of the ETF shares can be affected by the same factors that affect the underlying stocks.
However, ETFs do tend to be less volatile because a significant price change in one stock can be offset by how the other stocks in the fund are performing.
How is a mutual fund different from an ETF?
A mutual fund is similar to an ETF in that investors pool their money to buy a collection of stocks or other assets like bonds. Both mutual funds and ETFs have a mix of different assets, so they are good for adding diversity to your portfolio. Again, the benefit of diversity is that is lowers volatility and reduces risk because you are not dependent on only investment.
Unlike an ETF, however, mutual funds do not trade over exchanges and are not bought and sold like stocks. They are usually actively managed by a financial professional, who makes decisions about when to buy and sell the assets in the fund. ETFs are usually passively managed, meaning they just follow an index.
Traditionally, mutual funds are purchased directly through fund companies like Vanguard, Fidelity or T. Rowe Price, among many others. You can also use a broker or financial planner to buy into a mutual fund, although the fees are likely to be higher.
Mutual funds typically have dozens of securities, so, like ETFS, they can be a smart way to diversify your portfolio without the burden of picking and choosing the assets on your own.
For a small investor, buying shares of mutual fund does have a number of advantages, but also a few drawbacks to consider. Most mutual funds have a minimum investment requirement, typically of about $2,500. Also, investors may be charged fees, or commissions, for buying and selling. You may be charged ongoing fees for the cost of managing the portfolio.
You can review how well a mutual fund has performed to help you determine whether you want to buy it. Financial investors recommend looking at a fund’s three- to five-year performance instead of its short-term performance.
A quick note on Net Asset Value (NAV)
Another consideration when exploring how is an ETF is different from a stock is the concept of Net Asset Value (NAV). Funds – both ETFs and mutual funds – utilize NAV to describe the value of the assets contained within the fund. Since ETFs trade openly during the hours when the markets are open, the price of a share of the ETF can differ from the underlying NAV (or perhaps on occasion the NAV value might just not be updated to reflect real time prices). Mutual funds, which don’t trade during open market hours typically have their share prices updated after market close to match up with the changes in its NAV.
Is buying a stock or investment fund risky?
Each stock or investment fund is unique and carries its own degree of risk. Some are better for lower-risk portfolios while others are more ideal for portfolios aiming to maximize gains.
In general, stocks are perceived as a good investment in the long-term because they have historically increased in value. Of course, there is no guarantee on how they will perform in the future.
On average, S&P 500 stocks have an annual gain of 7% to 8%. Keep in mind that the historical average is over a period of many years, which includes rallies as well as downturns. Also, that doesn’t mean that each stock sees those gains.
Some stocks tend to make higher gains than others, but they also carrier a greater risk of declining. For example, technology stocks often see higher-than-average gains as investors anticipate demand for their products in the future, but they can also see higher-than-average losses.
Other stocks, like “blue chip” stocks, are more stable. “Blue chip” companies are multinational companies with established brands like Johnson & Johnson, Disney, PepsiCo or McDonald’s. They may not produce as impressive gains as a burgeoning tech stock, but they are also less likely to decline dramatically. “Blue chip” companies are known to weather downturns well, maintaining their profitability during different economic conditions.
The bottom line
Investing in ETFs is increasingly popular. However, both stocks, mutual funds and other securities may all be good investment choices to consider adding to your portfolio, depending on your situation.
Remember that individual stocks and ETFs vary widely, so research them carefully and compare them to your other investment choices. Weigh the costs, including commissions and fees.
ETFs have several advantages, such as allowing an investor to easily invest in several stocks or bonds at once. You can buy into an ETF with the ease of buying stock, while getting the benefit of diversity that a mutual fund provides. But for investors who want to target a specific company, stocks may be a better option.
No investment is a one-size-fits-all solution. Whether an ETF, stock or mutual fund is right for you and how much you should invest in it will depend on many factors like your investment strategy, your level of risk tolerance and investing goals.