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Why should you diversify when investing in ETFs?

Why should one diversify when investing in ETFs_

You technically diversify your portfolio when you invest in ETFs (exchange-traded funds). 

In fact, that’s one of the main benefits of investing in ETFs. Unlike when you buy individual stocks, if one company happens to have a bad day, your entire position isn’t affected nearly as much when that company is only a portion of the fund you hold. 

ETFs can provide broad exposure to a range of companies across different industries with just one, set and forget purchase, without picking stocks or feeling fear when one of those individual stocks hits a rough patch. 

However, there are some downsides to ETFs and holes in their supposed diversification, too, meaning you’ll likely still have to do a little manual diversifying of your own to craft a portfolio that’s truly “diverse” in nature.

Reason 1 to diversify: allocations 

Okay so, ETFs are supposed to be naturally diverse, right? Well, that might be a little presumptuous to think because it’s not always entirely accurate. 

Some of the market’s most popular funds have asset allocations that are heavily skewed toward their heaviest holdings, meaning stocks with a higher market cap hold more weight in the fund than others and therefore cast a significant influence on its price. 

For example, one of the most popular S&P 500 funds out there, $VOO, has its top ten holdings making up 29% of its fund weight, meaning a sizable portion of $VOO’s price movement is coming from Apple, Microsoft, Google, etc. If this fund were equally diversified, every 505 holdings would be weighted at about 0.20% each. 

Some will argue this is for a good reason and how funds should be allocated, whereas other investors would prefer a more equally distributed weighting. 

It’s been made known that the market correction we’ve undergone this year is essentially to blame on a few stocks at the top, which is another strike against market cap allocations. 

So, if this information finds you displeased, it might be time to diversify further by adding more variety to your ETF holdings. 

How does diversification help when the stock market is down?

Reason 2 to diversify: Customization

ETFs are preset baskets of stocks chosen by professionals whose entire job is to pick stocks that fit a set of criteria set forth for that particular fund. This can be nice for the hands-off investor who appreciates the simplicity and convenience of this investing style but a little too rigid for those who want a little more customization. 

The good news is we’ve made a lot of progress here, and there are now some very specific, niche, and customized funds out there designed for many different purposes and sectors alike. Perhaps it’s never been easier to hold a diverse set of ETFs in your portfolio.  

Suppose you happen to be of the investing style that prefers a little more involvement, or you may just be interested in a particular industry/company type. In that case, this is yet another good reason to diversify further outside of your typical broad ETFs and add something a little more targeted to your holdings too. 

Worried about volatility? Here’s how retail investors could deal with it.

At the end of the day

All-in-all, investing in even the most boring ETF could be  better than not investing at all, so we can’t hate that. But, it never hurts to learn, improve, and evolve even more as you grow as an investor, and now to understand that just holding an ETF doesn’t necessarily mean being diversified is a big step in the right direction. 

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