Which should you invest in?

ETFs often invest in stocks that have a specific focus area — for example, large companies, value-priced stocks, dividend-paying companies or those operating in a specific industry, such as financial companies. Some specialized ETFs allow you to potentially earn higher returns.

Most ETFs are passively managed, meaning that they replicate a specific index of assets, such as the S&P 500, a collection of hundreds of America’s largest companies, or the Nasdaq 100, a tech-heavy index. The ETF changes its holdings only when the underlying index changes its constituents.

An ETF’s return depends on what it’s invested in. An ETF’s return is the weighted average of all its holdings. So if it owns many strong stocks, the ETF will rise. If it owns many poorly performing stocks, then the ETF will decline.

Because of their wide array of holdings, ETFs provide the benefits of diversification, including lower risk and less volatility, which often makes a fund safer to own than an individual stock.

Investing in a stock can offer a lot of benefits, though it’s not without some serious drawbacks.

“The key advantage of investing in individual stocks is the potential to buy the market’s best performers,” says Baker. “Though that can require substantial time spent analyzing which of the market’s thousands of stocks is poised to outperform.”

• Investing in an individual stock can deliver very high returns, and you won’t be taxed on any capital gains until you sell in a taxable account. Investors who hold a stock for more than a year may enjoy lower capital gains tax rates.

• A single stock can potentially return a lot more than an ETF, where you receive the weighted average performance of the holdings.

• Stocks can pay dividends, and over time those dividends can rise, as the top companies increase their payouts.

• Commissions on stock trading have been slashed to zero at nearly all major online brokers, meaning the broker doesn’t charge to get in and out of an investment.

• You can still own the wealth-building power of stocks within an ETF or mutual fund.

• Stocks can fluctuate a lot from day to day and month to month, meaning you may need to sell at a loss and may never recover what you invested.

• Volatility can be dangerous for investors who have all their wealth tied up in just one or a few stocks. If that one stock does poorly, the investor has a lot of eggs in one basket and can lose a significant portion of wealth.

• Much effort is required to analyze and value individual stocks, and many people simply don’t have the time or desire to do so.

• You’ll need to pay taxes on any capital gains you generate, though you also have the ability to write off losses and get a tax break.

ETFs offer plenty of benefits to investors, whether they’re new to the game or are more advanced, though these funds don’t come without some drawbacks.

“The key advantage of investing in ETFs is the potential to earn strong returns while having to do only a little analysis,” says Baker. “This feature makes them especially attractive for newer investors who may not have the knowledge to analyze stocks but want stock-like returns.”

• ETFs allow you to buy one fund and have a stake in dozens, hundreds or even thousands of companies. Because of this broad ownership, ETFs offer the power of diversification, reducing your risk and increasing your returns.

• It takes little investing expertise to invest in ETFs and potentially earn high returns. A well-diversified ETF such as one based on the S&P 500 can beat most investors over time, making it easy for regular investors to do well in the market. Like stocks, ETFs can pay dividends.

• ETFs tend to be less volatile than individual stocks, meaning your investment may not swing in value as much.

• The best ETFs have low expense ratios, the fund’s cost as a percentage of your investment. The best may charge only a few dollars annually for every $10,000 invested.

• ETFs can be bought and sold any time the market is open, giving you a highly liquid asset, and they can be traded at no cost at major online brokers.

• You won’t be taxed on any capital gains until you sell the ETF in a taxable account.

• ETFs, even in a good year, will underperform the best stocks in the fund, meaning investors could have owned just those stocks and done better.

• ETFs do charge an incremental cost, the expense ratio, for owning the fund.

• Not all ETFs are the same, so investors do have to understand what they own and what it could return.

• You can’t control what’s invested in any single fund, though you don’t have to buy shares in that fund, either.

Buying individual stocks or ETFs can work better for individual investors in a variety of scenarios, and here’s when each one shines:

• You enjoy analyzing and following individual companies. It takes a lot of work to follow a stock, understand the industry, analyze financial statements and keep up with earnings. Many people don’t want to spend this time.

• You want to find outperformers. If you can find the stocks that will outperform — for example, Amazon or Microsoft — you can beat the market and most ETFs. However, it’s worth pointing out that this is extremely difficult and success is rare.

• You’re an advanced investor with time to devote to investing. Many investors enjoy following companies and tracking them over time. If that’s you, then buying individual stocks may be a great option for you.

• You don’t want to spend much time investing. If you’re looking for an easy solution to investing, ETFs can be an excellent choice. ETFs typically offer a diversified allocation to whatever you’re investing in (stocks, bonds or both).

• You want to beat most investors, even the pros, with little effort. Buy an ETF based on the S&P 500 and you’ll wind up beating the vast majority of investors over time. That’s right — passive investing with ETFs generally beats active investing.

• You’re a new or intermediate investor. ETFs are great for investors who are getting started, helping reduce your risk as your knowledge gets up to speed. But even many advanced investors invest in them, too.

• You want to invest in a specific trend without picking winners. Is there a hot new industry but you’re unable to pick which company will come out on top? Buy an ETF and get exposure to the whole sector at low cost.

Of course, it’s possible for investors to do both of these strategies. For example, you could have 90 percent of your portfolio in ETFs and the remainder in a few stocks that you enjoy following. You can hone your skills at investing in individual stocks without hurting your returns much. Then, when you’re ready you can shift to more individual stocks and away from ETFs.

The major difference in risk between an individual stock and an ETF is that a single stock is much more volatile than an ETF, which includes many stocks and therefore has lower volatility because it spreads out risk.

• Because an individual stock tracks the performance of only that one company over time, you have to own a winning company to make money. Pick a loser and you’ll lose money.

• In contrast, an ETF does well if the weighted average of the stocks does well. You have a lot of ways to win with an ETF, meaning they reduce your risk by being well-diversified.

However, the investment performance of both stocks and ETFs isn’t guaranteed by the government, and you could lose money on the investments.

Get matched: Find a financial advisor who can help you maximize your investments

ETFs make a great pick for many investors who are starting out, as well as for those who simply don’t want to do all the legwork required to own individual stocks. Though it’s possible to find the big winners among individual stocks, you have strong odds of doing well consistently with ETFs. Of course, you can blend the two methods as well, getting the benefits of a diversified portfolio with the potential extra juice from a few individual stocks on the side, if you want to test your skill.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.