HomeInsightShould you trade ETFs or Stocks or both?

Should you trade ETFs or Stocks or both?

new-york-631577_1920As a trader, you may have traditionally stuck with stocks as your main trading vehicle but you may have witnessed an explosion of ETFs or Exchange Traded Funds entering the markets since the beginning of the 21st Century.  I’ll assume you have a basic understanding of stocks and ETFs in this article (please click here if you need a refresher on the benefits of ETF trading and investing.)





Advantages of Stocks



Individual stocks are more volatile which gives them greater profit potential than the typical ETF.  Individual stocks also tend to be more predictable than ETFs which usually contain a basket of stocks and other securities (but don’t mistaken this to mean that they’re safer.)  This makes stocks better candidates for event-driven strategies which rely on exploiting market mispricings; it’s a bit difficult to assess the fair value of an ETF that contains dozens of stocks.



Disadvantages of Stocks



Well, what’s more fragile, an investment in a single company or an investment in a group of companies?  While the former can offer you tremendous upside especially if you happened to pick the next Apple, Tesla, Microsoft, Google, etc. it also offers tremendous downside if any catastrophe hits the stock you’re holding (i.e. Lehman Brothers in 2008) or even a simple earnings miss or analyst downgrade.  In 2014, GTAT (GT Advanced Technologies) went bankrupt and lost over 90% of its value in a matter of days and plenty of people lost a majority of their life savings due to it!  Now you might be thinking you’d be smarter and hold 5-10 stocks instead of putting everything into 1-2 baskets.  Yes, you’d be less exposed to catastrophic losses but you’d also have more securities to monitor and additional trading commissions to pay.  If you want to go this route, unless you’re trading full time and can constantly monitor each stock, you’re probably better off trading an ETF index fund rather than swing trading a basket of several stocks at once.



Advantages of ETFs



Most people might think of ETFs as a diverse collection of stocks packaged into a single security that can be traded in and out of like a stock but that’s just one type out of many.  There are ETFs for different asset classes like Gold, Treasuries, Real Estate, etc. as well as different strategies (2-3x Leveraged, Inverse/Short, Covered Calls, Hedged Foreign Indices, etc.)  The former offers you diversification benefits without the commissions and trading costs: imagine buying a market cap weighted portfolio of the S&P500 and rebalancing it regularly to reflect the index – the commissions will easily kill your returns even if you’re holding a 1 million dollar portfolio in a discount brokerage account!  On the other hand, the ETF manager can take advantage of their economies of scale and pass down the savings in a relatively negligible fee.



ETFs, IMO, are probably one of the best financial innovations since the 1990s because they offer the retail trader diversification benefits for minimal cost AND similar liquidity to stocks (unlike mutual funds.)  But the ETFs that invest in alternative asset classes like gold and treasuries are where things really shine.  It’s now possible to keep a well diversified portfolio consisting of multiple asset classes in a single location like one discount brokerage account instead of being spread out over multiple accounts thanks to these ETFs!



Disadvantages of ETFs



ETFs can be complex instruments due to the variety of securities they hold plus the plethora of investment strategies that some of them pursue, esp leveraged and short ETFs.  Some ETFs have substantial fees, particularly the ones involving alternative investments and active management, although they’re usually nowhere near what Mutual Funds charge.  ETFs also don’t offer the same upside potential as owning a “winning” individual stock.



My Thoughts



If you’re pursuing a buy and hold or swing trading strategy, ETFs are likely more suitable since you won’t be exposed to the rare but devastating unsystematic risks that afflict stocks.  In other words, you probably won’t be losing sleep over whether your investment will drop 50% or more overnight.  For a seasoned day trader who isn’t holding any positions overnight, trading individual stocks may prove to be more lucrative.  But if you’re a beginner, even when day trading, just stick with ETFs for now.