When it comes to investing everyone has their view on what you should be putting your money into. Plenty of people are convinced that you should only put your money into real estate, or cryptocurrency, or gold etc. There are also people who swear by the stock market, but these are usual split into two groups – Exchange Traded Funds (ETFs) or Individual Stocks.
There are pros and cons to both sides of the argument. Depending on your circumstances and risk tolerance one of these methods, or indeed both, could be suited to you. In this article we will discuss the advantages and disadvantages of investing into ETFs and individual stocks. I will also share my approach to investing into the stock market.
To start with, however, what is a stock? Investopedia puts it the best way, “a stock (also known as equity) is a security that represents the ownership of a fraction of a corporation” A unit of a stock is known as a share. Stocks predominantly are bought and sold on stock exchanges (or stock markets). An ETF is “a type of security that involves a collection of securities – such as stocks – that often tracks an underlying index.”
- Advantages of ETFs
- Advantages of Individual Stocks
- Disadvantages of ETFs
- Disadvantages of Individual Stocks
- My Approach to Investing into the Stock Market
Advantages of ETFs
There are two distinct advantages to investing in ETFs as opposed to individual stocks, they provide great diversity and exposure.
The first and main advantages of ETFs is their great diversity. When you invest into an ETF you could be indirectly buying parts of 20, 200 or even 2000 companies. Yet when you buy a share of an individual company you are only exposed to that company. While some companies have grown so large they are very diverse, you cannot beat an ETF.
So why is this diversity good? Diversity among stocks does two things, it allows you to invest in different companies in different sectors all within the same fund, and it spreads out your risk. The second thing, diversity of risk, is what makes ETFs so attractive. If you invest into a single company, your money is entirely tied to the performance of that single company. However, in an EFT your risk is spread out across tens or hundreds of companies. ETFs essentially are a safer way to invest into the stock market.
ETFs such as index funds will hold companies of that stock market index they are tied to and try to emulate its movements. So if you were to buy a S&P 500 index fund ETF you would indirectly own a share of 500 different large-cap companies from all sectors of the economy. This is how ETFs give you exposure.
Advantages of Individual Stocks
Individual stocks are a great way to invest, but only if you are confident in the stock you are investing in. You need to do quite a bit of research into the company you are looking to invest in, be that share price performance or reading company quarterly and annual financial statements. If you are not willing to put in the detailed research then ETFs are probably the best option for you.
Dividends are a key draw to investing into individual stocks, this is a particular draw for me. Not all stocks do pay dividends, instead retaining all their earnings to reinvest into the company for further growth, those that do however could provide a source of passive income. Over time if you invest consistently into good dividend paying stocks you could establish a credible source of income that will pay as long as dividends are still paid. Alternatively, if you reinvest those dividends to by more dividend paying stocks, this compounding effect could grow your portfolio to huge proportions.
If your £1,000 portfolio of dividend paying stocks earned a dividend yield of 3%, this would pay out £30 per year – a lot better than a bank. However if you reinvested that 3% while continuing to contribute £100 per month for 30 years your portfolio would be valued at £30,441.29 and pay you £1,744.32 in dividends.
Individual stocks can also do what no ETF can, they can beat the market. ETFs at best can only emulate the returns of a sector or index, they cannot beat their returns. The average annual return of the S&P 500 is roughly 8% per year, the FTSE 100 index is around 7.8%. On the other hand it is not uncommon for a stock to go up 20% or more in a single year. Even if your portfolio beats the market by only 1% this could be a difference of £1,000s.
Disadvantages of ETFs
To be honest ETFs do not have a lot of disadvantages. They are typically one of the most stable investments available to you as an investor. The one major fear that all investors have is that of so called “black swan” events, such as the 2007/8 financial crisis or the Covid-19 market crash in March 2020. That being said, seasoned investors will add to their positions rather than sell during these events.
The only real disadvantages of ETFs is that they cannot beat the market, and also the management fees that they can charge. Not being able to beat the market means you will never have massive growth in a short period of time. Fees will take away from your overall return.
One of the best things that ETFs have to offer is that they can track the market, thereby providing returns similar to the index they track. However the cost of this security and stability is you will never have any market beating returns. This is typically considered an opportunity cost, where you will miss out on a better investment due to you being entirely invested into ETFs. This draw back is why many stock market investors will add individual stocks to their portfolio. They have the security of the ETFs making a large part of their portfolio with a few individual stocks giving greater annual returns, therefore, overall beating the market.
Fees can be annoying, you want to be able to maximise your returns as an investor. Fees are the worst thing about ETFs, and they massively vary between ETF providers. I don’t like to pay any fees when investing, even small ones, especially if a fund manager cannot beat the market. It is even more a of a bitter pill when the fund value drops. So if you are going to invest in an ETF make sure you read all the fund information and pick one with low fees.
Disadvantages of Individual Companies
Individual shares don’t typically have many disadvantages when compared to their advantages. Investors, especially high profile ones such as Warren Buffet, have made enormous returns, something they could not have done through an ETF. However while individual companies can give market beating returns, they do not come without equal risk.
An ETF in theory cannot go to £0 per share, however an individual company’s definitely can. Individual companies can be a risk investment, any company can fail and become absolutely worthless. Some high profile collapses include Lehman Brothers (2008), Blockbuster (2010), and Thomas Cook (2019). While changes of this happening are rare, it can still happen. This is why it is important to do your research and ensure that the company you are investing in is financially sound.
As an investor you can also reduce your risk by investing into multiple individual companies instead of just one. Therefore, the returns of your portfolio could be based of, for example 15 companies.
My Approach to Investing into the Stock Market
So how do I invest into the stock market, do I invest in ETFs or individual stocks or both? I have chosen to invest into individual stocks. I like to take an active interest into my investments and I have the time to do that. There is a phycological impact that I like about being a shareholder of a large company such as Coca Cola or NatWest Group, albeit a very small shareholder.
But because I invest in individual companies I need to make sure I keep up to date with what is happening in the stock market. I am always reading business news on multiple apps such as Yahoo Finance, and every quarter I am reading through company financial statements. You need to pay special attention to things like cash flow, EBITDA, debt and dividend announcement; as well as the general direction that the company is taking.
My approach to investing in to individual stocks is to grow a dividend paying portfolio. First to benefit from compound interest, and second to eventually have dividend income supporting my every day life.