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Are ETFs a Better Investment Than Stocks? 3 Things to Know Before You Buy

When it comes to investing in the stock market, buying individual stocks is perhaps the most well-known way to build a portfolio. But exchange-traded funds (ETFs) are another popular option — one that often comes with less risk and far less effort.

An ETF is a bundle of securities grouped together into a single investment, with each fund tracking a specific stock market index. An S&P 500 ETF, for example, contains stocks from all the companies within the S&P 500 index itself. If you’re looking for a simple, straightforward way to invest in the stock market, ETFs can be a fantastic choice.

They do have their drawbacks, however, and they’re not the right fit for all investors. If you’re on the fence between investing in ETFs and individual stocks, there are three factors that can make it easier to decide where to buy.

1. ETFs can provide more diversification than individual stocks

In general, a well-diversified portfolio contains 20 to 30 stocks from a variety of market sectors. Proper diversification can help limit your risk, because if one or two of your stocks don’t perform well or are hit hard during a market downturn, it won’t devastate your entire portfolio.

Each ETF may contain dozens, hundreds, or sometimes even thousands of stocks. Some, like S&P 500 ETFs or total stock market ETFs, also contain stocks across many different sectors — meaning you can build a well-diversified portfolio with a single investment.

When buying individual stocks, it can be harder (and more expensive) to achieve proper diversification. You can buy a single share of an ETF for as little as a couple of hundred dollars, in many cases. Stocks often cost at least that much per share, and you often have to buy dozens to diversify your portfolio.

If you’re eager to jump into the stock market with as little time, effort, and money as possible, ETFs can be a quick way to begin investing. They don’t require as much research, and it’s far easier to build a diversified portfolio quickly.

2. It’s harder to customize your portfolio with ETFs

One downside of ETFs is that it’s nearly impossible to build a custom portfolio. When you invest in any ETF, you’ll instantly own a stake in all the stocks within the fund. There’s no way to opt out of certain stocks, so if there are particular companies or industries you’d rather not invest in, you’re out of luck.

For some investors, this isn’t necessarily a deal-breaker. The ease and simplicity of an ETF can often outweigh the lack of customization. But if you’re looking to build a powerhouse portfolio that fits your unique needs, individual stocks may be the way to go.

3. ETFs can carry less risk, but they may also experience lower returns

Because they’re so well diversified, ETFs often carry less risk than individual stocks. However, that level of diversification can sometimes result in lower returns. No matter which ETF you buy, not every stock in the fund will be a superstar performer. In fact, when you own hundreds or thousands of stocks through an ETF, most stocks will likely earn average or even below-average returns.

When you invest in individual stocks, however, you can craft a portfolio full of hand-selected companies with a greater chance of beating the market. And unlike with ETFs, you can sell any stocks that aren’t performing well and replace them with stronger ones.

To be clear, building a powerful portfolio of individual stocks does take far more time and research. But if your primary goal is to maximize your long-term earnings, you can potentially earn much more with a personalized portfolio than with an ETF.

There are advantages and disadvantages to investing in both ETFs and individual stocks, and the right choice for you will depend on your goals, risk tolerance, and the amount of time and effort you’re able to put into your portfolio. By weighing the pros and cons of both options, you can decide which is the best fit for your situation.

This post appeared first on fool.com

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