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ETFs and diversification: How to build a well-rounded portfolio

Diversifying with ETFs

Investing in the stock market can offer excitement and potential financial gain, but it's essential to recognize that all investments carry inherent risks. There are a few certainties regarding managing your money and navigating the stock market. 

That said, reliable investment columns will always emphasize the importance of understanding and managing risk, and they commonly recommend diversification as a critical strategy to mitigate potential losses. By diversifying your portfolio across various assets and industries, you can help safeguard your investments against market volatility and minimize your exposure to any particular area.

 

Diversification

Diversification is critical in reducing risks and establishing a robust investment portfolio. Exchange Traded Funds (ETFs) have emerged as a popular tool among investors for achieving diversification. Let's explore how you can leverage ETFs to diversify your portfolio effectively.

 

The basics of building a balanced portfolio

One of the primary goals of portfolio construction is asset allocation, which involves spreading your investments across different asset classes, such as stocks, bonds, and cash. The appropriate asset allocation for a given investor depends on their goals, risk tolerance, and investment horizon. 

For example, a younger investor with a longer investment horizon and higher risk tolerance may want to allocate a higher percentage of their portfolio to stocks. Older investors with a shorter investment horizon and lower risk tolerance may want to assign a higher portion of their portfolio to bonds.

The upshot here is that balanced portfolios should have diversified asset classes, but even within a balanced portfolio, there is scope for flexibility depending on each investor’s circumstances.

 

Diversifying with ETFs

ETFs are a popular investment vehicle for diversification because they expose investors to various markets and asset classes in neat predetermined packages.  ETFs are similar to mutual funds in that they pool investors' money to invest in a portfolio of assets. However, unlike mutual funds, they are traded like individual stocks on stock exchanges.

One of the significant advantages of ETFs over mutual funds is their lower costs. ETFs typically have lower expense ratios when compared to mutual funds and do not charge sales loads, making them the more cost-effective option for achieving simple diversification. Another benefit for those Investors seeking fluidity is that they can trade ETFs throughout the day, making them more liquid and easier to trade than mutual funds.

A final benefit of ETFs to point out is their access to markets and asset classes that may be challenging or time-consuming for individual investors to access otherwise. For example, an investor interested in emerging markets may need help to purchase individual stocks in these markets. They would need to research those companies but can easily invest in an ETF that tracks a broader emerging market index.

 

ETF investment options

ETFs are a popular investment tool that can help investors diversify their portfolios. They come in various types: equity, fixed-income, commodity, and currency ETFs. Equity ETFs expose investors to a specific segment of the stock market, such as large-cap stocks, small-cap stocks, or sector-specific stocks. 

ETFs can be either actively managed, meaning they are managed by a professional fund manager who actively selects investments intending to outperform the market, or passively managed, meaning they track a specific index or market and aim to match its performance.

Fixed-income ETFs invest in a bond portfolio, which offers exposure to different bond markets and maturities. Commodity ETFs invest in physical commodities such as gold or oil, while currency ETFs invest in currencies, providing exposure to the foreign exchange market. 

Investors should consider expense ratios, liquidity, and trading volume when selecting ETFs for a diversified portfolio. Additionally, investors should ensure that the ETF aligns with their investment goals, risk tolerance, and investment horizon.

 

Building a diversified ETF portfolio

Building a diversified ETF portfolio is an excellent way for knowledgeable investors to achieve long-term growth while managing riskInvestingng in a broad range of assets can reduce their exposure to any single investment and potentially enhance returns. 

The delicate aim is to understand that not all investments work out, so diversifying your portfolio lets you hedge your bets across different market areas. The oft-quoted 80/20 rule of investing also influences this thinking. 

Many investors will apply the 80/20 rule to portfolio management, where 20% of a portfolio’s holdings drive 80% of its performance. Put another way, and it suggests that 80% of a portfolio's risk comes from 20% of its holdings, highlighting the importance of diversification and risk management. Here are three simple steps to create a diversified ETF portfolio:

 

1. Determine your asset allocation

Base your asset allocation on long-term goals, risk tolerance, and time horizon. A typical distribution for a long-term investor could be 60% stocks and 40% bonds. Speaking to a professional advisor will help you dive minutely into these evaluations. 

 

2. Select the right ETFs

Selecting the most suitable ETFs based on your asset allocation is crucial to building a diversified portfolio. Look for ETFs that track broad-based indices or specific sectors or regions that align with your investment goals. It's also essential to consider the ETF's expense ratio, liquidity, and trading volume.

 

3. Rebalance the portfolio over time

Rebalancing your portfolio means periodically adjusting your asset allocation back to your original targets. This ensures you always align your portfolio with your investment goals and maintain diversification as years go by.

A balanced ETF portfolio can look different from investor to investor. Here is an example breakdown of how this might look like:

  • A conservative portfolio may include 60% in bond ETFs and 40% in stock ETFs weighted to the Nasdaq top 100.

  • A moderate portfolio may include 40% in bond ETFs, 50% in stock ETFs, and 10% in alternative asset ETFs.

  • An aggressive portfolio may include 70% in stock ETFs, such as the S&P 500, and 30% in alternative asset ETFs, such as sustainable investments.

It's crucial to monitor the portfolio regularly and make adjustments as necessary to ensure continued diversification and alignment with your goals. This includes reviewing asset allocation, evaluating ETF holdings, and staying informed about market trends and economic developments. 

Lastly, performing due diligence and seeking financial advice is crucial for investors considering investing in ETFs. ETFs are complex financial instruments subject to market volatility and other risks. By conducting thorough research and consulting with financial experts, investors can better understand the potential risks and rewards of investing in ETFs and make more informed decisions about their investment strategies.

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