We can never be one hundred percent certain what the market will do at any one time. Still, we should also never underestimate the value of a well-diversified portfolio in any market environment. To put it another way, a diversified portfolio can protect your investments from major losses, so it’s a good idea to not put all of your eggs in one basket.
Investing in exchange-traded funds (ETFs) is one strategy to diversify your portfolio. ETFs are a group of shares that have been aggregated into a single basket. They typically track a stock market index, such as the S&P 500, and are a simple, low-cost method to gain exposure to a wide variety of global businesses in one single share.
ETFs are a great vehicle for diversification because they give you access to a diverse range of businesses, industries, sectors, and countries all at once. That way, if one of the shares in the ETF is underperforming, your portfolio will be balanced out by other, better-performing shares.
- Why Diversification is important
- ETFs for diversification
- Stock (equity) ETFs
- Income (dividend) ETFs
- Developed markets
- Emerging markets
- Global diversification
- Conclusion
Why Diversification is important
Diversification effectively means holding a range of shares that respond differently to the same market conditions or economic events. It spreads your risk across many types of investments so that you increase your chance of achieving positive returns. Because markets can be volatile, diversification is essential in investing as it can mitigate the effects of a bad forecast.
Stocks, for example, tend to beat bonds when the economy is rising. However, bonds tend to hold their value better than stocks when the economy moves slowly. Overall, it’s quite rare for any two or three assets with differing sources of risk and reward, such as stocks, bonds, and commodities, to face major declines all at once.
As a result, even if stocks plummeted 40%, your bonds and commodities would save your portfolio from plummeting completely, because you’re holding multiple asset classes at once. This is why it is critical to diversify your investments, and this is easy to achieve through an investment vehicle like an ETF.
The key to diversifying your portfolio is owning investments that play different roles on your team. A soccer team made up of only strikers would lose more games than a team that includes other positions, such as defence. When it comes to your portfolio, the same rule applies: Every investment in your portfolio should have a different purpose.
In summary, the benefits of diversification include:
- Reduces volatility and the risk of major losses.
- Increases your chances of making a profit.
- Protects you from the effects of market downturns.
ETFs for diversification
So, what are the best ETFs for diversification? We know that ETFs will help us spread out risk, but there are thousands of ETFs to choose from, as well as a World Wide Web’s worth of investing knowledge to sift through. With investing, so much rides on making the correct decisions.
Understanding which ETFs are the optimum choice for diversification can be tricky, but we’re here to help.
Stock (equity) ETFs
ETFs that track an index of stocks are known as equity or stock ETFs. You can invest in ETFs that cover big companies, small companies, or stocks from a particular country. Equity ETFs also allow you to target industries that are performing well at a given time, such as banking or technology, making them a popular option.
The goal is to provide diverse exposure to a particular industry, comprising both high-performing companies and newcomers with growth potential. Equity ETFs, unlike stock mutual funds, also have cheaper costs and do not require actual stock ownership.
Some good choices include the SPDR S&P 500 ETF (SPY), by far the most popular and liquid of the index funds benchmarked to the S&P 500, as well as the iShares Core S&P 500 ETF (ticker: IVV). This iShares fund is worth highlighting due to annual costs being only 0.03%, compared to 0.095% for SPY.
Income (dividend) ETFs
Dividend ETFs provide exposure to a basket of dividend-paying stocks. Over the last decade, assets in dividend-distributing ETFs in the US, for example, have increased at an exponential rate. Dividend ETFs in the US owned less than $20 billion in assets in 2009, but had risen to about $300 billion by September 2021.
In both good and bad times, dividend stocks provide a regular stream of income and are thus favoured by many investors. The best dividend ETFs are diverse in terms of geography, sector, size, style, and other factors.
Good choices include the Vanguard Dividend Appreciation ETF (VIG), which tracks the performance of the S&P U.S. Dividend Growers Index, or the Fidelity MSCI Real Estate ETF (FREL) which is a Real Estate Investment Trusts ETF (or REIT). REITs have done well since the financial crisis and this one, in particular, provides access to a wide variety of properties.
Developed markets
Countries such as the US, UK, Japan and Germany are considered developed markets. Developed market exposures within a single fund allow access to a diverse basket of stocks from one or multiple countries.
This can mitigate the impact of a single company’s price volatility while also potentially improving the overall level of investment risk in a portfolio. Of course, remember that asset allocation and diversification do not completely shield you from the danger of your investment portfolio losing value.
Using a single ETF that tracks a broadly diversified world index weighted by market capitalization is key, and is also simple and cost-effective. You can opt for something like the iShares Core FTSE 100 UCITS ETF.
Emerging markets
You may have wondered about investing in shares listed in other countries or regions when there are political or economic uncertainties in your local country. When compared to other developed market investments, many emerging markets (defined as nations with low to middle per capita income) appear to be somewhat detached from happenings in developed markets.
Importantly, there is no single country that constantly outperforms the rest of the world. Outperformance would lead to relative overvaluation and a later reversal if one did. The key conclusion is that it’s hard to predict when and how the performance pendulum will swing, so global diversification is a smart idea.
ETF investors can profit from the price gains and dividends of the MSCI Emerging Markets constituents. Good options include the iShares MSCI Emerging Markets UCITS ETF USD (Dist) or the Lyxor MSCI Emerging Markets (LUX) UCITS ETF – Acc.
Global diversification
It’s worth noting that investing in a World Index ETF is actually a great hack that solves many of the problems new investors are trying to solve in one go, not just diversification. A World Index ETF invests in all of the world’s chief investable countries.
According to investing theory and knowledge from experience, there are key things the majority of investors should do for investing success:
- Diversify as much as is possible to reduce risk.
- Hold equities to attain long-term growth.
- Avoid attempting to outperform the market.
- Select basic, low-cost investment options.
A decent World Index ETF will cover all of these points. If you choose one that tracks a renowned index such as the MSCI World, you will be instantly invested in the world’s most successful companies and economies.
This is a wise decision because you are not dependent on the fortunes or misfortunes of one singular economy. When you ‘invest in the world’, you avoid disproportionate exposure to events like 2008, Brexit, Japan’s natural disasters, or any other catastrophic economic situation that can land upon a single nation.
By purchasing a World Index ETF, you are recognizing a fundamental truth: the best answer to the question “How should I allocate my money?” is the aggregate response of the world’s most knowledgeable investors.
Conclusion
Risks are often unpredictable and sometimes won’t even be captured by models (referred to as black swan events). Diversification is therefore absolutely essential. It is a common blunder to believe you can predict the future of the markets, and one should not simply get lured in by surges in individual stock prices without protection. With great opportunities comes great risk, so the key is to diversify, diversify, and diversify some more.
ETFs provide excellent opportunities for portfolio diversification, and the opportunity to hedge against the troubles and risks faced in different markets at different times. Holding ETFs reduces the investor’s exposure to risk as they are not dependent upon the success of one specific security or business, and the more globally diversified the better.
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