Investors often hear that one of the most important investing rules to remember may be to diversify. But why exactly? What are the benefits of diversification? And how can retail investors achieve diversification through exchange-traded funds (ETFs) or tracker funds?
Risk and return
We all know that in investing, risk and return go together. Where there is a potential return, there is also a potential loss.
To put it simply, diversification is all about reducing risk. As an investor, risk can either be your best friend or your worst enemy. Whenever you buy a company’s shares, you’re taking on some degree of risk. For example, the company might go bankrupt or a global financial crisis might adversely affect the UK market.
Diversification will not eliminate all the risk in your equity portfolio. But your long-term risk/return ratio is likely to be more attractive.
Once you have decided how much of your wealth you would like to have in equities, it is time to look at how you want to allocate your money among different types of shares.
An example of two companies
Let us see how diversification could work if you held only two companies in your portfolio. For example, a big drop in the price of oil might hurt you if you were invested in oil giant BP.
But if you also held shares in International Consolidated Airlines Group the owner of British Airways, a company where the largest variable expenses are fuel costs, you might find that the potential appreciation in the IAG share price goes a long way to offsetting the decline in BP shares.
And when you add the current dividend income from holding the shares of both companies, then you may find that the volatility in the market may not necessarily be so difficult to navigate.
ETFs and tracker funds
But two companies only do not make a diversified portfolio. If you are new to investing or do not have the time to select multiple pairs of companies that enable you to diversify fully, then ETFs or tracker funds could be the way forward. Both are passive investments that track a particular index without attempting to outperform it.
Although many retail investors understandably regard them as similar investment vehicles, the main difference between them lies in the investment flexibility being offered.
ETFs are traded on stock exchanges and can be bought or sold, like shares, at any time during the trading day.
Tracker funds are structured as a unit trust or open-ended investment company (OEIC) and priced once a day.
Those investors who are not sure whether ETFs or tracker funds are more appropriate for their portfolios may want to consult a registered financial advisor before investing.
One example of an ETF would be the FTSE All-World ETF, tracking the performance of a large number of stocks around the globe.
If you’d like to have domestic exposure only, you could instead buy into a FTSE 100 tracker fund.
In short, such a passive investing strategy could broaden your exposure to a wide range of asset classes, giving you the opportunity to diversify your holdings.
These funds can also be held in an Individual Savings Account (ISA), enabling investors to benefit from tax-free income and capital gains.
tezcang has BP covered calls (July 19 expiry) on BP ADR shares listed on NYSE. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.