Diversification in ETF portfolio
Using ETFs to properly diversify your portfolio
As the stock market continues its historic climb to new heights, investors may be growing a bit wary of the next big correction, which is really not question of if it will come, but when. While it has been a great ride if you happen to be invested in stocks, it has come at cost, which is the tremendous about of volatility that typically accompanies big stock market gains. If you invested in an S&P 500 ETF between 2006 and 2016, your annualized return was 6.7%. However, during that time, you had to withstand a standard deviation, or annualized risk, of 15.25%. That degree of volatility is unsettling to most investors, which is why they are driven to irrational behavior – selling out of fear or buying out of greed, both of which typically lead to portfolio under-performance.
Diversification is key to long-term performance
While you never completely 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 the various assets 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 declining stock prices. When the stock market looks to correct or turn volatile, bonds become a safe haven due to their yields and relative stability. Investor 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%. Granted, stock values recovered and have since gone on to record highs. However, if you owned bond investments at the time, your portfolio would have had far less from which to recover.
Exchange-Trade Funds as natural diversification vehicles
ETFs are perfectly 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, a portion of your investments can be allocated 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 the expertise of professional management. Investment portfolios, whether they are invested in stocks, bonds or both, must be constructed around the risk and return profile of the individual investor. Even with that, portfolios are dynamic, requiring constant monitoring and adjustments through market cycles and as individual 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.