Diversifying Your Stocks with an ETF

ETF and stocks provide different investment returns for an individual investor. It is appropriate to consider investing in an ETF contact when an individual investor lacks the capital necessary to fully enjoy the benefits of investing in a broad based number of stocks. ETFs require a lower capital outlay than a comparable stock investment and as such is desirous of smaller investors who are looking to participate in the market.

Exchange Traded Funds versus Stocks

An ETF, or exchange traded fund, is a fund that is designed to track the returns and performance of an underlying index, such as a Lehman Brothers bond index, the S&P 500 stock index or the Russell 2000 index, etc. The purpose of an ETF is to mirror the returns of the index through passive investment techniques without necessarily outperforming those returns. This is where an ETF differs from a mutual fund, which is actively managed by an investment manager in order to produce returns.

An ETF is sold over the counter primarily through the NASDAQ  trading system. It is through the NASDAQ that you can find current information on returns, relative to a particular ETF that you may be interested in. The type of ETF that you choose as part of your portfolio depends on different factors. These factors include your investment objectives, goals, investment time horizon and risk tolerance level.

Risks Associated with ETFs versus Stocks

One of the chief reasons to consider using an ETF is to lower the overall risk exposure to your portfolios. ETFs, like other types of investment company shares, provide investors with instant diversification. What this means is that you have a broader exposure to different types of stocks or securities than if you build a portfolio by purchasing shares of the individual stocks underlying the ETFs index. You also have a lower capital outlay associated with an ETF than when you purchase individual stocks.

A portfolio consisting strictly of stocks of individual companies can expose you to sector or concentration risk, depending on how the portfolio was constructed. Even if you consider yourself a careful “stock picker,” most non-professional investors tend to make simple mistakes that translates into lost investment opportunities or avoidable losses. Many of these problems can be reduced by adding an ETF that is counter to your portfolios weight. For example a portfolio consisting mainly of small value growth stocks that represent a particularly high level of risk relative to a high potential return can be balances with more large company growth stocks or utilities to provide a base of income opportunities. This can be accomplished by using an ETF of the like index.

Achieving Portfolio Diversification

The best way to achieve diversification within your portfolio of stocks is to first measure the relative level of risk, as compared to the potential return. The portfolio’s beta, which is a measure of a portfolio’s volatility relative to the market as a whole, should be no higher than 1. A beta that runs at 2, or higher, should send up a red flag to begin the process of diversification in order to reduce the risk exposure.

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