Financial Advice
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

Using ETFs to Diversify Your Portfolio

Using ETFs to Diversify Your Portfolio

After more than a decade of steady gains, the recent volatility in the stock market reminds us once again of the importance of diversification for long-term investing. While you may never be able to eliminate the innate sense of fear you might feel when investing in stocks, you can offset it with a greater sense of confidence through proper diversification. Diversification, which is recognition of the fact that we cannot predict the direction of the market or when certain asset prices will rise or fall, is the absolute key to long-term investment performance.

Modern portfolio theory (MPT) provides us with all the evidence we need to know how various asset classes behave differently from one another. This means that each asset class has a unique risk and return profile, which causes them to react differently during changing economic and market cycles. A well-diversified portfolio contains a mix of assets with low correlation to one another to act as counterweights, capturing returns whenever and wherever they occur while reducing portfolio volatility.

Stocks and Bonds Together Increase Returns While Reducing Volatility

During periods of declining economic growth or market corrections, bonds can provide the antidote to falling stock prices. When the stock market looks to correct or turn volatile, bonds become a safe-haven due to their yields and relative stability. Investors who owned bond investments during the big market crash of 2008 were able to contain the loss in portfolio value when pure stock investors lost as much as 40%. Although stock values recovered and have since gone on to record highs, if you owned bond investments at the time, your portfolio would have had far less from which to recover.

Examples of Low-Correlating Investments or Assets:

Stocks / Bonds

Gold, precious metals / Stocks or U.S. dollar-based assets

Stock mutual funds / Real estate investment trusts (REIT)

U.S. stocks / International stocks

Exchange-Trade Funds as Natural Diversification Vehicles

ETFs are constructed to provide investors with a vehicle for achieving asset class diversification at a low cost. Because they are passively managed with portfolios designed to mirror various stock and bond indexes, their expense ratios are a fraction of those found with actively managed funds. When you own an S&P 500 ETF, your investment is automatically diversified among 500 stocks or 2000 stocks in the case of a Russell 2000 ETF. For instant diversification into European or global markets, you can allocate a portion of your investments towards ETFs that cover those sectors. Because you are investing in specific indexes, sectors, or regions, there is far less chance of overlap in the underlying investments.

The Extra Advantage of Professional Management

While ETFs make it easier for individual investors to construct diversified portfolios, there is no substitute for professional management expertise. Investment portfolios, whether they are invested in stocks, bonds, or both, must be constructed around the individual investor’s risk and return profile. Even with that, portfolios are dynamic, requiring constant monitoring and adjustments through market cycles and as personal circumstances change. Professional managers are adept at working with the broad universe of more than 5,000 ETFs to create the ideal portfolio tailored to investors’ objectives, preferences, and risk tolerance. For most investors, the extra peace of mind is worth the extra half point in fees paid.

Archive