The Importance of Diversification and How to Achieve it with ETFs

 

 

 

The Importance of Diversification and How to Achieve it with ETFs

 

For most investors, investing in stocks can be intimidating at best and downright horrifying at worst. Yet, despite the wild fluctuations that do occur, the stock market still offers the greatest potential for growth over the long-term. While it has been proven that trying to time the market or pick individual stock winners with any degree of consistency is nearly impossible, there is a way to invest long-term with a far greater chance of generating positive returns while also reducing portfolio volatility – and that is through diversification.

 

Through diversification, your portfolio is exposed to many different stock market segments, which means it won’t be subject to the extreme volatility of any single market segment. For example, investors, who are invested solely in Russia MICEX stocks, have experienced a decline of nearly 10% since the beginning of 2017. But, had they also invested in stocks from other regions of the world, such as Europe, the U.S., and Asia their portfolios might show a gain for the year. The major indexes in Europe and Asia are all positive through August 2017 and the U.S. S&P 500 index is up more than 10%. The gains in these markets would have more than offset the losses in the Russia market.

 

Spread Your Risk and Capture all the Gains

 

Diversification is the recognition that it is very difficult to know which market sector will outperform another sector and that different sectors or asset classes perform differently from one another. So, instead of trying to guess, diversification allows you to capture the returns wherever and whenever they might occur while keeping the overall volatility of your portfolio low. When properly done, a diversified portfolio should outperform a more concentrated portfolio over the long-term.

 

The key is to choose non-correlating assets to mix into your portfolio. For example, stocks and bonds are non-correlating assets – when stocks are performing well, bonds tend to underperform . But at least bonds continue to generate a yield when their prices underperform. When stock prices decline, bond prices tend to rise, so they provide counterweight to declining stock prices. Real estate is also a good hedge against declining stock prices.

 

The Key to Building Wealth: Reduce Volatility and Losses

 

The key to building wealth is not through seeking big gains in your portfolio; rather it is through minimizing your losses during market declines. It used to be that, if you wanted to construct a diversified portfolio of stocks and bonds, you would need a large amount of money – upwards of $1 million – to do so properly. That’s because you would need to purchase a basket of individual stocks and bonds large enough to achieve broad diversification. However, investors can now invest any amount of money in a basket of securities through exchange-traded funds (ETFs).

 

ETFS: The Perfect Diversification Vehicle

 

ETFs are designed to provide investors instant diversification in any market sector at a low cost. Most ETFs are invested in a particular stock index or a specific segment of stocks. Instead of owning just a few stocks in that sector, you can own a whole basket of stocks covering the entire index or sector. For example, the VanEck Vectors Russia ETF tracks an index of more than 100 stocks that are incorporated in Russia or that receive at least half their revenue within Russia. You could combine that ETF with ETFs invested in other regions throughout the world; and within those regions, you can invest in ETFs that focus on certain sectors of the economy, such as real estate, high technology, financial services or manufacturing. With a $50,000 investment, it is possible to own dozens of ETFs for the broadest diversification possible.

 

Low Costs and Better Performance

 

Most ETFs are passively managed, meaning they don’t buy and sell securities inside the portfolio except to adjust the weighting of the portfolio. For that reason, ETFs are very inexpensive, with expense ratios just a fraction of actively managed funds. The other advantage of investing in a passively managed fund is that, over time, they have outperformed the more expensive actively managed funds. History has shown that active investors who try to pick individual stocks and time the market consistently underperform the indexes. If you can invest passively, without having to worry about which stocks to own or when to buy and sell them, and still outperform active investors, why would you consider investing any other way?

 

 

As easy as it is to invest in ETFs – they can be bought and sold on the stock exchange just like a stock – there is still a lot that goes into creating an asset allocation that best suits your particular investment profile. You don’t want to assume more risk than is necessary while trying to achieve a level of returns that will achieve your investment objective. That’s why it is recommended that you work with a professional money manager who understands the entire universe of more than 2,000 ETFs and can help you construct a portfolio tailored to your specific profile.

 

 

 

Vitali Butbaev