Investing in the stock market is one way of accumulating wealth. And once you dip your hands in the investment ocean, the next logical step is to reduce your risk of losing your investment. And how to do that? One method is diversification.
By diversifying, you put your money on several kinds of assets, so if one asset goes down, the loss is offset by the other assets who haven’t been affected.
You can reduce the overall risk associated with your investment portfolio through strategic and thoughtful diversification.
Benjamin Graham, widely regarded as Warren Buffett’s mentor, expanded on the merits of diversification in his best-selling book “The Intelligent Investor” (1949).
“There is a close logical connection between the concept of a safety margin and the principle of diversification.” — Benjamin Graham
Sir John Templeton, too, believed in diversification and rightfully said, “Diversify. In stocks and bonds, as in much else, there is safety in numbers.” Let us follow this apt adage and learn how to diversify your stock portfolio.
The goal of diversification is to reach an optimal risk-to-reward ratio. It is meant to reduce the volatility of the portfolio despite swings in the market in either direction, up or down.
Through a reduction in exposure to a single stock or company or even an asset class, the impact of price movement on the portfolio value as a whole is reduced. Further, through diversification, in a variety of asset classes or sectors, exposure to Unsystematic Risk, i.e. risk related to a specific company or industry, can be reduced. As a result, the overall risk (or volatility) of a portfolio can be reduced at a given return expectation.
It is important to note that the goal of diversification is not to maximise the absolute returns of a portfolio but rather to optimise the risk-return economics of a portfolio.
What are the different types of portfolio diversification?
- Across Time Frames
Consider the time range that an investment operates in while making your decision. Due to their higher inherent risk, long-term bonds can occasionally provide higher rates of return; nevertheless, short-term investments are more liquid but offer lesser returns. The overall investment maturity length of the portfolio also supports diversification.
For instance, if you have a 10-year fixed deposit, the liquidity aspect would be most impacted because your money will be restricted until the end of that period. Of course, you are free to take money out at any moment before maturity, but you will be charged fees and get considerably less money than if you had waited.
Whereas diversifying your investments by choosing fixed deposits with different maturities, such as 2, 3, 5, or 10 years will protect you from the liquidity factor.
- Across Asset Classes
Portfolio diversification across asset classes refers to the distribution of your investments among various asset classes, such as equities, bonds, gold, silver, mutual funds, and fixed or recurring deposits.
Depending on the broader macroeconomic situation, various asset categories react in different ways.
Alternative assets are an emerging asset class that goes beyond purchasing stocks and bonds.
Real estate, cryptocurrencies, commodities, precious metals, and other assets are now straightforward for investors to invest in, thanks to the advancement of digital technology.
- Across Borders
A portfolio’s geographic location is crucial to its diversity. You can take advantage of currency changes by investing in the shares or assets of one or more nations if the rules permit.
You can also invest in real estate abroad. Political, geopolitical, and international challenges have a greater impact on the policies of larger nations.
The monetary policies of the various countries will, however, affect the opportunities and hazards in different ways. Thus, regional portfolio diversification helps you to acquire advantages and lower risks.
- Across Sectors
A significant level of industry diversity may be obtained by purchasing the stocks or bonds of businesses operating across various industries. Stocks can be categorised by sector or industry.
The S&P 500 index, for instance, consists of equities from businesses operating in 11 distinct industries. Businesses in the real estate and finance industries suffered enormous losses during the Great Recession of 2007–2009. Losses in the healthcare and utility sectors, however, were less large. Industry variety is a key strategy for reducing investment risk.
Why should you diversify your stock portfolio using an ETF?
Exchange-traded funds are normally passively managed. A fund manager selects the stocks and bonds for the fund in the first scenario. Instead of actively selecting stocks, the method just watches an index.
Active funds, however, seek to outperform market returns. However, active managers did quite poorly in the previous year. Over 80% of all actively managed U.S. stock mutual funds lagged by their benchmark in 2021, according to S&P Dow Jones Indices.
Some stock sub-categories were worse. About 85% of American large-cap stock funds underperformed the S&P 500, which is the second-worst percentage ever.
ETFs and index funds are a much simpler alternative here. They also offer lower expense ratios, a fee that mutual fund companies charge to manage your money, than actively managed mutual funds.
You’ll often find that ETFs are less expensive when compared to index funds. ETFs have proven to be a solid financial product in terms of returns and costs, so let us further understand the advantages if we diversify a stock portfolio using ETFs:
- Unlike mutual funds, exchange-traded funds (ETFs) can be easily traded like stocks before the market ends.
- Since many ETFs are passively managed investments linked to an underlying index or market sector, their expense ratios usually tend to be lower than those of mutual funds. On the other hand, mutual funds are often handled more aggressively.
- Using ETFs rather than stocks can provide immediate diversification. An ETF that tracks an index for financial services, for example, enables you to buy many financial firm stocks instead of just one.
- And of course, ETFs can be invested across time, geography, assets and sectors, as mentioned before. This gives you the advantage of mitigating risks that can be found in one category while reaping the benefits in another.
How to Diversify your Stock Portfolio Using ETFs
Exchange-Traded Funds (ETFs) are an attractive vehicle to diversify your portfolio. The ETF industry has exploded in popularity over the years and offers a lot of opportunities to diversify your portfolio.
Diversification through ETFs can be done in a variety of ways. In the section below, we cover a preferred way to diversify through investing in three asset classes and also provide options for implementation through leading ETFs. Let us understand how to diversify your investment portfolio below:
- Domestic Equities
Equity markets are often the aggressive part of a portfolio and offer high growth potential in the long term. Equities can substantially increase the volatility of portfolios in times of stress, like in the current market conditions. However, historical analyses show the U.S. market to be extremely resilient and rewarding over the long term.
Investing in the broader domestic U.S. market can be achieved through the following ETFs:
|ETF Name||Region||Total Assets ($MM)||YTD Price Change||Avg. Daily Volume||Previous Closing Price||1-Day Change||ETF Database Pro Tools|
|SPY||SPDR S&P 500 ETF Trust||North America||$373,540||-12.15%||90,680,400||$414.17||-0.07%|
|IVV||iShares Core S&P 500 ETF||North America||$308,888||-12.16%||6,086,450||$416.32||-0.10%|
|VOO||Vanguard S&P 500 ETF||North America||$273,976||-12.13%||5,504,413||$380.77||-0.08%|
|VTI||Vanguard Total Stock Market ETF||North America||$271,797||-13.34%||4,402,298||$207.75||-0.10%|
|QQQ||Invesco QQQ Trust||North America||$176,810||-18.20%||70,048,416||$324.40||0.47%|
|VTV||Vanguard Value ETF||North America||$99,325||-5.67%||3,013,042||$137.15||-0.61%|
|AGG||iShares Core U.S. Aggregate Bond ETF||North America||$83,441||-7.88%||7,875,580||$103.87||0.24%|
|BND||Vanguard Total Bond Market ETF||North America||$83,000||-8.07%||6,961,229||$76.87||0.25%|
|VUG||Vanguard Growth ETF||North America||$78,926||-19.34%||1,432,550||$258.21||0.49%|
Bonds are often a source of interest income and tend to be less volatile than equities. They are more predictable and can offer more capital safety as compared to Equities. However, return expectations also tend to be lower. Bonds can vary from extremely safe U.S. Treasuries and AAA corporate bonds to more risky high-yield bonds.
Few of the leading Bond ETFs are:
|Symbol||ETF Name||Total Assets ($MM)||YTD||Avg Volume||Previous Closing Price||1-Day Change|
|AGG||iShares Core U.S. Aggregate Bond ETF||$81,849.50||-8.51%||84,31,719||$103.36||0.78%|
|BND||Vanguard Total Bond Market ETF||$81,524.60||-8.72%||71,72,956||$76.48||0.82%|
|BNDX||Vanguard Total International Bond ETF||$44,721.80||-8.17%||31,55,257||$50.42||0.84%|
|VCIT||Vanguard Intermediate-Term Corporate Bond ETF||$41,913.50||-10.62%||66,47,200||$81.86||0.66%|
|VCSH||Vanguard Short-Term Corporate Bond ETF||$41,166.10||-4.55%||56,48,397||$76.93||0.46%|
|BSV||Vanguard Short-Term Bond ETF||$38,751.70||-3.97%||48,40,689||$77.14||0.38%|
|LQD||iShares iBoxx $ Investment Grade Corporate Bond ETF||$33,457.70||-13.10%||1,98,75,344||$113.63||0.77%|
|TIP||iShares TIPS Bond ETF||$30,910.40||-6.98%||50,84,313||$115.93||0.84%|
|MUB||iShares National Muni Bond ETF||$29,174.40||-6.28%||64,28,028||$107.97||0.47%|
|SHY||iShares 1-3 Year Treasury Bond ETF||$26,747.70||-2.82%||66,35,970||$82.86||0.25%|
iii) International Equities
Foreign equity markets can also be attractive opportunities to invest in. Many foreign markets are distinctly different from U.S. markets and can provide a much-needed boost to risk management through investing in non-correlated assets.
Also, investing in emerging markets can help investors achieve high returns through explosive growth anticipated in a few of the developing and growth-oriented markets.
The below foreign market focussed ETFs are top choices:
|Symbol||ETF Name||Country||Total Assets ($MM)||YTD||Avg Volume||Previous Closing Price||1-Day Change|
|IEMG||iShares Core MSCI Emerging Markets ETF||Broad Asia Pacific ex-Japan||$65,218.10||-18.40%||1,86,97,456||$48.29||-0.98%|
|SCHD||Schwab US Dividend Equity ETF||U.S.||$35,564.60||-9.23%||32,36,276||$72.18||-0.43%|
|EEM||iShares MSCI Emerging Markets ETF||Broad Emerging Markets||$26,007.80||-18.62%||4,95,56,040||$39.42||-1.00%|
|JPST||JPMorgan Ultra-Short Income ETF||U.S.||$20,253.30||-0.32%||49,61,410||$50.12||0.02%|
|SCHZ||Schwab U.S. Aggregate Bond ETF||U.S.||$7,398.03||-8.68%||11,49,944||$48.65||0.72%|
What are the steps for building an ETF Portfolio?
- Determine the asset allocation as per time frame/ risk appetite/ sectors
First, determine your investment objective, which might be anything from retirement to paying for education. Your asset allocation is determined by your expected returns and risks, time horizon (the longer it is, the more risk you can bear), personal situation, and how this portfolio fits into your overall investment strategy.
- Implement your strategy
The best thing about ETFs is that you may choose one for whatever industry or index you want exposure to. Determine which of the available funds will best help you reach your allocation goals by analysing them.
- Monitor and assess
Examine your portfolio’s performance at least once a year. Depending on your tax situation, the beginning or end of the year is best for investors. Assessing an ETF’s performance with respect to its benchmark index is crucial. There should not be many tracking mistakes, to be specific. If there are mistakes, you might want to switch to a fund that will invest in accordance with its stated investment philosophy. To correct any imbalances that may have arisen due to market swings, balance the weightings of your ETFs.
More diversification options
ETFs allow many more opportunities to diversify a portfolio. Alternate strategies include ETFs, such as:
- Sector or Thematic funds
- Commodity-focused funds (Gold, Silver, etc.)
- Real estate funds
- Asset allocation funds
Go ahead and diversify your portfolio and achieve your financial goals.
STAY DIVERSIFIED! STAY SAFE!
Frequently asked questions:
- Are ETFs a good way to diversify a portfolio?
ETFs, many of which are passive products that track a certain benchmark index, provide excellent diversification at a modest cost per share. As a result, they frequently offer transparency, making it straightforward to determine what stocks, bonds, or other items the ETF frequently owns.
- How many ETFs are needed for a diversified portfolio?
Each ETF contains a basket of several stocks and securities. Hence, it is up to you as an investor to determine how many ETFs you need to hold depending on your risk tolerance, budget and goals.
- What ETFs should I buy for a diversified portfolio?
The ETFs you should invest in depend on factors such as your timeline, goals, and even the sector or idea you would like to invest in. As a starting point, you may refer to the numerous ETFs mentioned in Stockal’s platform.