Through strategic and thoughtful diversification, investors can reduce the overall risk associated with their investment portfolio.
Investors often try to optimize their portfolio through diversification. In a nutshell, diversification is a process of allocation of the corpus in a portfolio, across a variety of investments.
By doing so, investors tend to limit their risk of exposure to a single asset or asset type. Through strategic and thoughtful diversification, investors can reduce the overall risk associated with their investment portfolio.
Benjamin Graham, widely regarded as Warren Buffett’s mentor, expanded on the merits of diversification in his best-selling book “The Intelligent Investor” (1949).
“There is a close logical connection between the concept of a safety margin and the principle of diversification.” — Benjamin Graham
The goal of diversification is to reach an optimal risk-to-reward ratio. It is meant to reduce the volatility of the portfolio despite swings in the market in either direction, up or down.
Through a reduction in exposure to a single stock or company or even an asset class, the impact of price movement on the portfolio value as a whole is reduced. Further through diversification, in a variety of asset classes or sectors, exposure to Unsystematic Risk, i.e. risk related to a specific company or industry, can be reduced. As a result, the overall risk (or volatility) of a portfolio can be reduced at a given return expectation.
It is important to note that the goal of diversification is not to maximize absolute returns of a portfolio but rather to optimize the risk-return economics of a portfolio.
How to diversify using ETFs?
Exchange-Traded Funds (ETFs) are an attractive vehicle to diversify your portfolio. The ETF industry has exploded in popularity over the years and offers a lot of opportunities to diversify your portfolio.
Diversification through ETFs can be done in a variety of ways. In the section below, we cover a preferred way to diversify through investing in three asset classes and also provide options for implementation through leading ETFs.
ii) Domestic Equities
Equity markets are often the aggressive part of a portfolio and offer high growth potential in the long term. Equities can substantially increase the volatility of portfolios in times of stress, like in the current market conditions. However, historical analyses show the U.S. market to be extremely resilient and rewarding over the long term.
Investing in the broader domestic U.S. market can be achieved through the following ETFs:
Bonds are often a source of interest income and tend to be less volatile than equities. They are more predictable and can offer more capital safety as compared to Equities. However, return expectations also tend to be lower. Bonds can vary from extremely safe U.S. Treasuries and AAA corporate bonds to more risky high yield bonds.
Few of the leading Bond ETFs are:
iii) International Equities
Foreign equity markets can also be attractive opportunities to invest in. Many foreign markets are distinctly different from U.S. markets and can provide a much-needed boost to risk management through investing in non-correlated assets.
Also, investing in emerging markets can help investors achieve high returns through explosive growth anticipated in a few of the developing and growth-oriented markets.
The below foreign market focussed ETFs are top choices:
More diversification options
ETFs allow many more opportunities to diversify a portfolio. Alternate strategies include ETFs, such as:
– Sector or Thematic funds
– Commodity-focused funds (Gold, Silver, etc.)
– Real estate funds
– Asset allocation funds
Keep an eye on subsequent mailers for information on alternate diversification options, the performance of such strategies, risk & mitigation ideas, and other model portfolio opportunities.
Go ahead and diversify your portfolio and achieve your financial goals.