Building a portfolio involves more than simply picking stocks you think will appreciate. We believe it’s about combining stocks you think will appreciate in a way that balances upside potential with downside risk management.
That’s why wealth advisors recommend diversification. If you own only one stock, then your entire investment rises and falls on the performance of one company’s stock. If you own only one sector, or one asset class, or one anything, your investment will similarly rise and fall with that sector or asset class.
But if your portfolio is diversified, meaning it holds investments from multiple asset classes, sectors or geographies, then your winners could still drive the overall portfolio higher while your losers may have less opportunity to tank the whole thing.
We could write a book on diversification and all the ways an investor might achieve diversification without diluting the power of the winners. While there are lots of strategies for diversifying a portfolio, we believe ETFs can be an excellent tool to execute those strategies.
A variety of options
While diversification can happen along multiple axes (asset class, sector, geography, etc.), a primary strategy is often diversifying among asset classes. That’s because different asset classes have different benefits and drawbacks, and they often don’t perform in lockstep. When large caps are winning, small caps may not be, and vice versa. Owning both can take advantage of their tailwinds while minimizing their headwinds.
There are nearly 4,000 ETFs listed in Morningstar’s database. Many of them are traditional index funds, which typically means they track a market index that is generally tied to a single asset class, like the S&P 500 or the Russell 2000. Even ETFs that track a proprietary index are often tied to a single asset class; our own Motley Fool 100 Index ETF (TMFC) is restricted to large-cap stocks, while Motley Fool Next Index ETF (TMFX) holds small- and mid-caps.
You can find ETFs that invest in particular sectors, geographies, or even vehicles like bonds.
No matter what you’re trying to do—create an entire diversified portfolio with ETFs or fill in a gap in an existing set of investments—there’s probably an ETF for that.
Low expenses
Passive ETFs generally have low expense ratios, especially compared to mutual funds, often because they’re index funds or are in another way passively managed. Even actively managed ETFs, in many cases, can often have lower expense ratios compared to similar actively managed mutual funds because of the overall lower cost structure of an ETF compared to that of a mutual fund.
Today, many popular brokerage sites offer ETF trades with low, or in some cases, no trading commissions.
Any expenses you have to pay to invest lower your overall returns, so it’s important to pay attention to how much you’re spending. Using ETFs as a diversifier can help keep your portfolio expenses low.
Easy to buy and sell
ETFs make buying baskets of stocks just as easy as buying individual stocks. They’re traded during the trading day, just like individual stocks, and you’ll see the additional shares in a retirement or taxable investment account right away.
Selling ETFs is just as easy. You’ll see the cash proceeds from the sale in your account right away, though there is a settlement period that might require you to wait to use that cash to purchase something else.
Unlike mutual funds, ETFs can be used with stop orders or limit orders, just like individual stocks. This can help you hedge against price fluctuations and exert control over a portion of your portfolio.
ETFs can, in some cases, add liquidity where an individual security might lack it to a degree. For example, trading in certain types of bonds can be difficult for individual investors. Using an ETF that invests in these types of bonds can be the most efficient way to gain access to them.1
General tax efficiency
ETFs are generally more tax-efficient than corresponding mutual funds due in large part to their structure. This attribute makes them a tool for building a diversified portfolio in your taxable investment accounts.
ETFs can also be a good choice for diversification when you’re tax-loss harvesting. Tax-loss harvesting is a strategy of selling unprofitable investments at a loss to offset investments you’re selling at a gain. However, the wash-sale rule says you can’t purchase the same security you sold or a substantially identical security over a 61-day period covering the 30 days before and after the sale.2
An ETF can help serve as a substitute for the security that was sold at a loss. If you sold shares of an individual stock, buying an index ETF in the same asset class or perhaps one that tracks the same business sector as the stock that was sold can be a way to maintain your portfolio’s asset allocation while taking advantage of tax-loss harvesting without violating the wash-sale rule.
Diversification made easy
We believe ETFs can be an excellent tool for building a diversified portfolio without the hassle of balancing individual stocks against one another. They’re typically inexpensive, generally tax efficient, and they are themselves already diversified because they hold multiple securities.
If you’re building a portfolio from scratch or looking to fill a gap in an existing portfolio, check out the six ETFs we offer, covering everything from global investments to capital efficiency and every asset class along the way.
5 min read
