Nobel Prize laureate Harry Markowitz, the creator of Modern Portfolio Theory (MPT) famously called diversification "the only free lunch in investing."
What Markowitz meant by this was that by combining numerous uncorrelated assets with positive expected returns, you could create a portfolio with better overall risk-adjusted returns.
While each individual asset may be volatile on its own, the volatility of the portfolio when these assets are mashed together might be lower without compromising expected returns.
When some assets zig, others zag, thus helping to offset losses and spread-out risk. To put it simply, diversification means putting your eggs in many baskets.
Thanks to the popularity of exchange-traded funds (ETFs), attaining maximum diversification has never been simpler. If you're looking to diversify your portfolio by investing in ETFs, this article is for you.
How to Create a Diversified Portfolio With ETFs
Diversifying your portfolio isn't as simple as just throwing together a few different ETFs and calling it a day. To ensure proper diversification, consider following these five steps:
Determine your investment circumstances
The first step is to answer three questions. First, determine your investment objectives. What are you investing for? Second, determine your time horizon. When will you need to spend the money? Finally, determine your risk tolerance. How much volatility are you willing to endure? Answering these questions honestly is a holistic process that will help you determine your asset allocation.
Determine your asset allocation
Your portfolio's asset allocation refers to what asset classes it holds, and in what proportions relative to each other. Think of it like a cake recipe – for maximum deliciousness, you want the right amounts of egg, flour, sugar and milk. Too much of one, and the whole thing is ruined. To determine your asset allocation, it's important to understand the fundamentals of stocks, bonds, commodities and cash. Each of these assets has different risk-return profiles and responds differently to macroeconomic conditions. For example, stocks tend to have the highest long-term expected returns, bonds tend to provide income and safety during bear markets, commodities shield against inflation and cash provides safety in a crash. A great example of a highly diversified portfolio is Harry Browne's Permanent Portfolio, which holds stocks, Treasury bonds, cash and gold in equal 25% allocations.
Screen for the right ETFs
Once you have your asset allocation set, it's time to pick the right ETFs. Pick an asset class, like stocks and screen for equity ETFs in that space. You can further refine the list by filtering for geography (e.g., U.S. stocks only), market cap (e.g., large-cap stocks only) or sectors (e.g., tech stocks only). For maximum diversification, consider holding a market-cap-weighted index ETF of global equities. Then, repeat the process on the bond side by screening for bond ETFs and filtering for geography and credit quality. Generally, a U.S. aggregate bond ETF holding a mixture of Treasury bonds and investment-grade corporate bonds is considered diversified. Finally, you can add a commodities and money market ETF if your asset allocation calls for it.
Dig deep into your ETF selection
Once you have a list of prospective ETFs to invest in, it's time to dig deeper. Look up the prospectus of each ETF and its ETF fact sheet. Examine the ETF's current holdings. For equity ETFs, make sure the ETF isn't overly concentrated in a single stock or sector. For bond ETFs, check the ETF's average duration, which is a measure of interest rate sensitivity and overall credit rating, a measure of default risk. Make sure you read up on the risks outlined in the ETF prospectus, which covers the various scenarios that could cause you to lose money. Finally, check that the ETF has a reasonable expense ratio. All else being equal, lower fees are better.
Buy your ETFs and manage your portfolio
Once you have your final ETF picks narrowed down, it's time to buy. A good practice is to use limit orders to minimize bid-ask spreads. Once you have your ETFs purchased, the only thing left to do is reinvest distributions when paid out and rebalance your portfolio back to its target asset allocation on a periodic basis, usually annually or quarterly.
Why Diversify Your Investment Portfolio?
A diversified portfolio does two things — it produces the same expected returns as an undiversified one for lower risk, or it targets the same risk as an undiversified one but produces higher expected returns.
It’s the only free lunch in investing you'll get. Here are some reasons why you should diversify your investment portfolio:
It reduces tail risk: A tail risk is an extremely unlikely yet catastrophic event. The more diversified a portfolio is, the lower the probability and impact your tail risk become. For example, holding just a single stock exposes you to a much greater likelihood of the company going bankrupt. If it does, the impact is that your entire portfolio goes to zero. By holding hundreds of stocks and adding bonds, the risk of this event becomes insignificant.
It offers peace of mind: By diversifying your portfolio, you no longer need to stay on top of economic releases or earnings reports. By investing in a globally diversified portfolio of different assets you can sleep better knowing that your long-term returns aren't dependent on a specific company or sector doing well, a single country outperforming or a particular asset gaining value. You might not beat the market, but you're unlikely to underperform it either.
It lowers volatility: High and frequent fluctuations in your portfolio aren't good. Excessive volatility can cause investors to panic sell or induce deep drawdowns that take a long time to recover from. By holding multiple different assets that aren't perfectly correlated, a diversified portfolio smooths out its overall volatility compared to an undiversified one.
Why Invest in ETFs?
Investors don’t have to use ETFs when it comes to diversifying a portfolio, but they do have some key advantages that make them great candidates. These include:
Simplicity: An investor can create a portfolio holding thousands of stocks and bonds with just one or two ETFs, making it easy to monitor and rebalance a portfolio.
Low fees: Passive index ETFs can have expense ratios as low as 0.03%.
Transparency: ETF holdings are published regularly by their fund managers, making it easy to keep up-to-date with their current holdings.
Compare ETF Brokers
Investors looking to research and choose the best ETFs can use Benzinga to compare the available options. Here is a list of brokers that support ETF trading and offer research tools to help investors select the right ETF.
Frequently Asked Questions
How many ETFs are needed for a diversified portfolio?
The question of how many ETFs are needed for a diversified portfolio ultimately depends on the breadth of the ETFs being selected. If you’re focusing on broad-market, global equity and bond ETFs, then a diversified portfolio can be created with as little as two ETFs. Asset allocation ETFs aim to achieve diversification via a single ticker. These ETFs hold an all-in-one portfolio of global stocks and bonds allocated in various ratios based on different levels of risk tolerance.
How do you find balanced ETF investments?
Finding balanced ETF investments ultimately boils down to doing the nitty-gritty work of reading an ETF’s fact sheet and prospectus. There’s no shortcut for putting in the time and effort to examine an ETF’s holdings and strategy thoroughly. However, using online ETF screening services could help you expedite this process and narrow your search.