Diversification and ETFs

Imagine you own 10 eggs. You paid $1 for each of those eggs. You read online about an egg seller who will collate your eggs into a basket and go door to door and sell each egg for $2. We’ll call this egg seller the market darling. You deposit all 10 eggs with the market darling hoping to double your money. Ask yourself though, what if the market darling trips on his/her way to the first house? You’ve literally put all your eggs into 1 basket and taken on a good amount of risk.

Instead imagine you deposit each of your eggs with separate egg sellers. 1 egg with the market darling, 1 egg with an egg seller who might sell at $1.20, another at $1.50, another at $0.90 and so on. The market darling might trip, but you’ve diversified your investment and your risk has been reduced. This risk minimisation strategy isn’t free. You’re foregoing a potentially larger return by not depositing each of your eggs with the market darling.

Investors diversify their investments in much the same way. They build portfolios with portions of their capital allocated towards different classes of assets. They might even diversify further within those asset classes. For example, an investor might allocate a portion of his/her property holdings towards residential property and the remainder towards commercial property. The same investor might allocate various portions of his/her equities holdings towards various industries (e.g. financial services, industrials, tech, healthcare etc). This means that it’s not the end of the world if one of your eggs start to show signs of cracking.

Risk

Before we get to how you can diversify, there’s something important you should understand about risk. How much you diversify (or even if you diversify at all) depends on your willingness to take on risk. An investor who can assume more risk might opt to deposit all 10 of his/her eggs with the market darling. An investor who can’t assume as much risk might opt to diversify. We call the latter type of investor ‘risk-averse’. It’s often wise to have a risk-averse mindset but it’s important to understand that most, if not all investments do carry some degree of risk and that being too risk-averse can seriously cost you in the long run.

How do you diversify?

Assets move up and down in value at different rates. Stocks might be performing well in one quarter, property might be performing well the next. Most portfolios are generally made up of different asset classes. That’s one method of diversification. As highlighted above, you can diversify further by investing in different securities within the asset classes you’ve chosen. Let’s say you’ve decided to allocate a certain portion of your portfolio towards 4 stocks. It would make little sense to exclusively hold mining stocks if your goal is to diversify your investments and minimise your risk. You would be diversifying your investments by investing (for example), 25% of your allocated capital in a mining stock, 25% in a healthcare stock, 25% in a tech stock, and 25% in utilities. Alternatively, you can diversify by investing in an ETF.

What is an ETF?

An exchange-traded fund, or ETF is essentially a fund made up of a portfolio of assets (basically the basket in our example above). ETFs trade on securities exchanges such as the ASX. Many ETFs track a ‘benchmark index’. For example, there are many ETFs available which track the ASX 200 – an index of the top 200 companies listed on the ASX. An investor might be interested in investing in this type of ETF if he/she thinks the ASX 200 is going to deliver a good return. The investor would also be minimising his/her risk. If 3 or 4 of the ASX 200 companies in the ETF deliver poor results and each suffer a 20% drop in share price on a single trading day, that would unlikely make a dent in your ETF’s value. However, if you only held 1 stock which suffered the same drop, you’ve lost, well 20%. That’s a fifth of your portfolio’s value – take it from someone who’s been in this position, it’s not fun to watch.

ETFs are not just designed for investors looking to track a benchmark stock market index. Some examples of other types of ETFs include:

  • industry specific ETFs (ETFs which invest in companies in specific sectors such as tech or industrials);
  • fixed income ETFs (mostly made up of bonds);
  • commodity ETFs (underlying assets might include gold, iron ore etc);
  • derivative ETFs (we will get to derivatives in another article); and
  • dividend ETFs (ETFs with a focus on high dividend yield stocks).

Other benefits

Diversification is expensive. If you wanted to diversify your portfolio yourself by accruing 20 or 30 stocks, your brokerage fees might be quite high. You would pay brokerage fees each time you entered or exited a position for each of these stocks. An ETF however gives you access to a number of stocks with a single brokerage fee payment. Obviously, there are downsides to this method too. For example, if you build your own portfolio, and you believe one of your 20 or 30 stocks are soon headed for a slump, you can exit your position relatively easily. With an ETF you have no control over the assets the fund holds.

ETFs and similar products are well known for giving new investors the opportunity to access low-cost, lower-risk investments with small amounts of capital. Some of these products even allow investors to buy into these positions with as little as $1. Most investors buy into ETFs which track well-known benchmark indices such as the ASX 200. New investors are given cheap, easy access to the market and with skin in the game (no matter how small), investors feel more invested (hehe) in how markets are performing. Money-making might not be the main priority here, considering how little a micro-investor might be investing. Investing in ETFs therefore can also be an educational experience. A new investor might be more willing to understand how the macroeconomic landscape (such as foreign trade numbers, monetary policy decisions, unemployment results etc) affects the market as a whole, and therefore their own shareholdings.

P.S. birkenstocks suck