What is stock?
When a publicly listed company wishes to raise funds for its venture, it issues stocks, also known as shares, on stock exchanges such as the Bombay Stock Exchange. Depending on how many individual stocks you own, you have a certain percentage of ownership in that company. Also, if you buy preferred stock, then you are not eligible to vote in the company’s decisions but get preference over those holding common stock when it comes to receiving dividends of the company’s profits. There are thousands of listed companies on the market in whose stock you can invest.
Types of stocks
Stocks are of two types- common stock and preferred stock. While both represent ownership of a company, there are some differences between the two. In this article, we will look at the difference between common stock and preferred stock.
1. Common stocks
When you purchase common stock, you get partial ownership of the company. Common shares also come with the legal right to elect the board of directors. Hence, they also have control over corporate policy and management decisions of a company.
When a company fails, the common stockholders have the lowest priority when it comes to getting back any of their money. Creditors who have lent money to the company get paid back with top priority. Even if some money is left after paying the creditors, the holders of preferred stocks get paid next. This is subject to a maximum amount. Only if money is left even after that, common stockholders get paid.
2. Preferred stocks
One difference between common stocks and preferred stocks is that preferred stocks do not have voting rights.
There are two main reasons why these stocks are called preferred stocks. Holders of preferred shares receive regular dividends which are higher than those received by holders of common stocks. Preferred stocks pay dividends which are agreed upon beforehand unlike common stocks which pay dividends based on how profitable the company is. A company has to pay dividends to its preferred stockholders before it pays any dividend to its common stockholders. When it comes to risk, a preferred stock is riskier than a bond but less risky than a common stock.
Preferred stocks can be of a few types. In the case of convertible preferred shares, you have the option to convert a preferred stock into a common stock. Preferred stocks may also be cumulative. This means that the company may postpone dividend payments when it is not performing well. But when the situation improves, they have to pay the dividends in arrears. This has to be done before any payment is made to common stockholders. Another type is a redeemable preferred stock where the company has the right to redeem the stock at a date in the future.
What is ETF?
While stocks are just one instrument, an ETF is a basket of securities consisting of diversified investments such as stocks, commodities, bonds, and other securities. These funds are called holdings. The shares to these holdings are then sold to investors by the fund manager. In India, ETFs first arrived on the investment scene in 2001. Today, there are several ETFs in India from which to choose.
Other types of ETF
Usually an ETF is meant to make money as the value of the fund increases, that is, when the market or at least the set of stocks that the fund has invested in is bullish. However there is another type of ETF that acts as the exact opposite. It is called an Inverse ETF.
What is an inverse ETF?
This type of ETF benefits when the status of the index it tracks falls, as the name implies. It is made up of derivatives including futures contracts, options, and swaps, among others. A ‘short ETF’ or ‘bear ETF’ is another name for an inverse ETF. When a market undergoes price drops, it is referred to as a “bear” market.
Inverse ETFs typically invest in daily futures. When the index falls by 2%, the inverse ETF climbs by 2%. An inverse ETF is a short-term investment because it is based on derivatives such as futures contracts, which are exchanged daily.
What are leveraged inverse ETFs?
Aside from derivatives, debt can be used to boost the index’s results. Returns can be boosted by a factor of 2:1 or even 3:1 with a leveraged inverse ETF. This reflects that if the NIFTY 50 from the previous example falls 3%, your 3x leveraged inverse ETF will rise 9%.
Advantages Of Inverse ETF
In your investment portfolio, it functions as a contrast to standard ETFs. If you have standard ETFs tracking a benchmark index, having an inverse ETF tracking the same index means that if the index loses points, your inverse ETF compensates for it and more.
Disadvantages Of Inverse ETF
The first drawback stems from the high expenditure ratios. Because inverse ETFs are actively managed funds, this is the case. However, you will be better rewarded if you own inverse ETFs for a short period of time. In the long run, shorting stocks or index funds is a superior option.
Similarities ETF and Stocks
Before you consider the points for stock vs ETF, remember that they hold significant similarities.
- Both are taxable
- Provide an income stream
- Offer hundreds of options
- Can be bought on a margin and sold short
- Both can be traded on the stock market throughout the trading day.
Differences between stocks and ETFs:
- Investing in an ETF is associated with lower risk as it is diversified. You are investing in a portfolio of different entities, and it is unlikely that all of them will lose their value. On the other hand, investing in individual stocks can be riskier, especially if you put all your eggs in one basket. If the company loses its value, then your stock’s value falls, and there is no other investment instrument to nullify that loss.
- ETFs require a professional to manage the investment for you, whereas investing in stocks doesn’t necessarily need a broker. You can do your research and build a robust portfolio.
- An ETF has a higher transaction fee compared to when you buy individual stocks. However, the expense ratio and broker fees are usually lower for ETFs.
- Your ETF is managed by a professional saving you the trouble of deciding which portions of the ETF to sell or hold. In the case of individual stocks, you will need to keep an eye on the market to know when to buy, sell, or hold. Inversely, in the case of ETFs, you do not have control over what happens to the portions of your ETFs; while in stocks, you have control over what stock selection.
Conclusion
Just like any other important aspect of your life, investing also depends on your research, personal preferences, and the guidance of someone experienced. You will have to put in a reasonable amount of effort to identify your financial goals and understand your appetite for risk. For professional guidance, take the help of an advisor or broker to help you choose the best investment options to secure your future.
FAQs
Stocks vs ETF: What is the difference?
Stocks are shares of a single company and they represent a partial ownership interest in the company’s profit and loss. ETFs are pooled funds invested in a bundle of securities and assets, such as stocks, bonds, or commodities.
Which one offers better diversification: stocks or ETFs?
ETFs generally offer better diversification than individual stocks. ETFs invest in a basket of securities, providing exposure to multiple companies or assets.
Are stocks or ETFs more suitable for active trading?
For active traders, stocks are more suitable due to their potential for greater volatility. Also, they allow traders to target specific company stocks better. ETFs are a type of passive investment that offers exposure to a diversified portfolio.
Which one is more cost-effective: stocks or ETFs?
The cost of investing is the primary difference between ETFs and stocks. ETFs tend to have lower expense ratios, making them more cost-effective than other options like mutual funds. However, if you consider trading costs, stocks have lower transaction fees. ETFs may incur brokerage commissions, which may eventually lower your returns.
Stocks vs ETFs: Which is better for liquidity?
Both stocks and ETFs have higher liquidity compared to other investments. However, stocks are slightly more liquid than ETFs because of their significant trading volume. The liquidity of an ETF fund depends on the specific fund and the underlying asset.
