BUYING INDIVIDUAL STOCKS VS ETFS: PROS, CONS & STRATEGY

One of the primary differences between buying individual stocks and investing in exchange-traded funds (ETFs) lies in the concept of diversification — a key principle in investment strategy aimed at reducing risk. While both approaches can serve varying investment objectives, their impact on diversification is significantly different.

Individual Stocks: Lower Diversification

Investing in individual stocks means purchasing shares of a single company. As a result, the investor is exposed to the performance, risks, and volatility of that specific business. Although it's possible to construct a diversified portfolio by selecting stocks across multiple sectors or industries, doing so requires substantial capital, research, and ongoing management.

Even when spread across multiple companies, diversification achieved through individual stocks is often limited by price sensitivity. For example, gaining broad market exposure would require purchasing shares in dozens of companies, which may not be feasible for average investors. Moreover, individual stock performance can be significantly affected by company-specific news such as earnings reports, executive changes, or regulatory developments.

ETFs: Built-In Diversification

Exchange-traded funds offer built-in diversification by pooling investor money into a fund that holds a broad basket of assets. These can include stocks, bonds, or other securities across sectors, industries, or geographies depending on the ETF’s objective.

For instance, a broad-market ETF like the FTSE All-World or S&P 500 ETF grants exposure to hundreds of companies in a single trade. This spread reduces the impact of any single company's performance on the overall portfolio. Sector-specific ETFs allow targeted exposure (e.g. technology or healthcare) while still spreading risk within that sector.

Additionally, thematic or multi-asset ETFs further enhance diversification by allocating investments across broader strategies, including global equities, commodities, or fixed income assets. This makes ETFs an appealing option for investors seeking exposure without the overhead of researching each holding individually.

Which Offers Better Diversification?

In terms of sheer diversification, ETFs generally provide a more efficient and accessible route than purchasing individual stocks. They help reduce unsystematic risk — the risk associated with individual companies — by distributing capital across multiple holdings. This is particularly advantageous for new investors or those with limited time and capital to build a diversified, well-balanced portfolio one stock at a time.

However, stock pickers who are confident in their research and market timing may seek higher returns through concentrated investments in high-performing companies. The trade-off, of course, is higher exposure to volatility and potentially significant losses if those companies underperform.

Effort and time commitment play a significant role when deciding between managing individual stocks or investing in ETFs. Both investment vehicles offer the potential for financial growth but differ substantially in terms of the hands-on involvement they require.

Individual Stocks: Time-Intensive Approach

Investing in individual stocks demands a strong understanding of market dynamics, financial analysis, and corporate fundamentals. Investors need to conduct thorough due diligence, which includes evaluating balance sheets, earnings reports, market trends, and competitive positioning. Moreover, making informed stock picks requires ongoing monitoring of news, earnings releases, and potential risks for each individual company owned.

Beyond initial research, maintaining a diversified portfolio with multiple individual stocks also increases the need for rebalancing, capital gains tax planning, and response to market events. For those investing in more volatile sectors or smaller-cap companies, staying ahead of movements becomes an even more time-consuming task.

This hands-on approach may appeal to experienced or hobbyist investors who enjoy active management and are comfortable navigating changeable market conditions. However, for individuals with limited time or knowledge, the workload can become burdensome.

ETFs: Low-Maintenance Investment

In contrast, ETFs offer a relatively passive investing experience. Thanks to their inherently diversified structure, there is minimal need for constant oversight on individual holdings. Investors can gain broad market exposure through a single trade, which simplifies portfolio construction.

Many ETFs follow an index strategy, meaning they track and replicate the performance of a specific benchmark such as the MSCI World, FTSE 100, or S&P 500. This 'buy-and-hold' style requires significantly less time commitment and virtually eliminates the need for ongoing research into each holding.

Although periodic reviews are still advisable to ensure alignment with financial goals, the effort involved is considerably reduced compared to stock selection. Rebalancing also tends to be less complex, especially when ETFs are used within tax-advantaged accounts like ISAs or SIPPs in the UK.

Time vs Control: What Matters Most?

If you're an investor with professional knowledge or a strong interest in the market, the tactical control of individual stock picking may be appealing. However, for the majority of retail investors, ETFs present a time-efficient and cost-effective solution that removes much of the stress involved in stock-by-stock decisions.

The growing popularity of robo-advisors and model ETF portfolios also underscores this point: many investors now prefer simplified, automated solutions over the responsibility of researching and managing individual shares. Ultimately, the decision may come down to how much time you are willing — and able — to spend managing your investments.

Risk is an unavoidable aspect of investing, whether through individual stocks or ETFs. However, the type, degree, and management of risk differ considerably between these two approaches. Understanding these distinctions is essential to aligning your investment strategy with your risk tolerance and financial objectives.

Individual Stocks: Higher Volatility

By nature, investing in individual stocks carries a higher, more concentrated risk profile. The performance of your portfolio can hinge significantly on the results of a few companies. Sharp price fluctuations, corporate scandals, missed earnings, or sudden changes in management can lead to substantial drops in stock prices — and, by extension, your investment value.

This security-specific risk, known as unsystematic risk, can be mitigated through diversification — but achieving a diversified portfolio through individual stocks takes effort and capital. Investors who put significant capital into a few stocks face higher exposure to these risks, which makes individual stock investing inherently riskier for most individual investors.

Nevertheless, the potential for outsized gains exists. Investors who identify undervalued or high-growth companies at the right time may realise strong capital appreciation. This often comes with a trade-off: the possibility of more pronounced losses.

ETFs: Reduced Risk Exposure

In contrast, ETFs offer lower exposure to unsystematic risk because each fund contains a basket of assets. Losses from underperforming companies can often be offset by gains from others within the same ETF. This dampening effect on volatility makes ETFs a less risky choice for most retail investors.

That said, ETFs are not immune to market risk (systematic risk). For example, an ETF tracking a broad index will still decline when market-wide downturns occur. Sector-specific or leveraged ETFs may still carry higher risks depending on their structure, strategy, and underlying investments.

Importantly, ETFs also carry liquidity and price risks. While most ETFs trade like stocks on public exchanges, some niche or low-volume ETFs suffer from low liquidity, potentially making them more volatile or harder to trade at fair value.

Managing Risk Based on Goals

For most long-term investors, ETFs offer a balanced approach that aligns with moderate risk tolerance. Their diversified nature and passive structure allow investors to benefit from broad market gains while limiting concentrated losses. They are particularly suited to those seeking steady growth over time without excessive exposure to volatility tied to specific companies.

On the other hand, individual stocks offer greater customisation and opportunity for alpha (outperformance) but require comfort with higher volatility and the discipline to manage downside risks. Investors with shorter time horizons or lower risk tolerances may find the unpredictability of individual stocks more difficult to manage.

In summary, ETFs generally present a lower-risk option due to diversification, while individual stocks come with more potential for high returns — as well as significant losses — depending on the investor's skill and market conditions. Your personal risk appetite, investment goals, and investment timeline will ultimately determine which is the better fit.