We have all heard that we should be diversifying our exchange traded fund investment portfolio to make for better investing. But do you know why you’re doing it? Diversifying can accomplish two objectives.
Does an investor receive better diversification through total stock market funds, queries Mike for The Oblivious Investor, or by adding other types of stock funds?
Ultimately, the reason may depend more on why you want to diversify.
Reduce risk. Many would say that diversification is a way to spread your investments over as many companies as possible, and if that were true, then the Wilshire 5000 fund fits the bill, remarks Mike. The Wilshire 5000 index includes REITs, value stocks and small-cap stocks, making it a rather well-rounded index.
- SPDR Dow Jones Total Market (NYSEArca: TMW)
Reduce volatility. Some, though, would argue that the point of diversification is to reduce overall volatility in a portfolio. In this case, you would seek out investments that have low correlations with the rest of your portfolio. If you have volatility reduction in mind, you could look for funds that have similar long-term expected return compared to the rest of your investments, similar volatility to the rest of the portfolio and behaves differently from the rest of your investments.
For instance, large-cap value funds have similar expected returns and similar volatility compared to total market funds, but the month-to-month and year-to-year performances differ.
- SPDR Dow Jones Large Cap Value (NYSEArca: ELV)
For more information on investing, visit our ETF 101 category.
Max Chen contributed to this article.