There are a lot of misconceptions about what successful investing means. Some people associate it with betting on the right company and making a bundle when its stock rises. Others think of it as buying a series of bonds when you’re young and cashing in on them when retirement approaches.
But there’s a middle ground. And that’s where diversification comes in.
Diversification means spreading your money among a variety of assets such as stocks, bonds and cash. This way, you get exposure to different securities and investments while also reducing your exposure to risk by not putting all your money eggs in one basket.
Let’s say that 50% of your holdings were in one company’s stock. If the stock price fell by half due to unexpectedly low earnings or a scandal in the C-suite, it would cause a 25% loss in your portfolio value. But if that company only made up 0.5% of your portfolio, that dip would barely be noticeable. That’s the benefit of diversification.
As you get started on your investing journey, or are considering rebalancing a portfolio you already have, it’s helpful to understand your options. Here’s a look at some of them.
An exchange-traded fund (ETF) provider packages up various investments, such stocks, bonds and other assets, and allows you to buy shares of that package—so it’s an easy way to diversify the holdings in your portfolio right off the bat.
Like a stock, an ETF can be traded on an exchange, meaning you can buy and sell it at any point throughout the trading day (unlike mutual funds, for example, which can only be traded at the end of the day). ETFs are also more transparent—most publish their holdings daily—and have some tax benefits since you are typically only taxed when you sell the investment.
There are also different types of ETFs. Most are index-based, meaning that they track and invest in a securities index like the S&P 500. Actively managed ETFs invest to follow a stated investment objective or asset type, such as large-cap growth stocks or companies with sustainable practices.
When considering an ETF, take a good look at what’s inside its wrapper, says Indianapolis-based certified financial planner Brent Perry of Piedmont Financial Advisors. While many ETFs offer healthy diversification, that’s not true for all of them. If you prefer a hands-on approach, investing in ETFs is easy to do through online brokers, or if you want to outsource your investing, you can go through a robo-advisor.
Similar to ETFs, mutual funds allow you to buy shares of a portfolio of stocks, bonds and other assets. With actively managed funds, the managers research, select and monitor the securities, so they tend to have higher fees than index funds or ETFs—in 2020, the average expense ratio for actively managed equity mutual funds was 0.71% versus 0.18% for index equity ETFs.
As stated earlier, an index fund is a mutual fund or ETF that tracks a particular stock index, such as the S&P 500. Index funds that mimic the S&P 500—composed of 500 large companies listed on U.S. stock exchanges—are incredibly popular as they offer exposure to a wide variety of industries—yet there are plenty of other index funds out there, such as ones that track international markets or are focused on bonds.
“It’s very easy to be diversified within index funds,” Perry says.
What’s great about index funds is that you don’t have to pick individual stocks or worry about adjusting your investment style. But if you want even less responsibility, a target-date fund is a good place to start.
A target-date fund is a hands-off investing tool that focuses on your desired retirement date. For example, a 25-year-old who wants to retire in her mid-60s might purchase a 2060 target-date fund (meaning they want to retire in 2060), while someone who is 55 might select a 2030-oriented fund.
These funds are managed so that their allocations change as time goes on. The investor in the 2060 fund likely has more exposure to stocks than the 2030 fund investor, but the 2060 fund will gradually become more conservative over the years. The goal of these funds is to have reduced risk and more security as you approach retirement age.
Target-date funds are “usually incredibly diversified,” holding assets such as U.S. and global stocks, cash and bonds, Perry says.
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Zina Kumok is a freelance writer who specializes in personal finance.