If you are researching diversification, I’d imagine you are probably concerned about volatility in your portfolio. A well-diversified portfolio is an excellent goal!
You are not wrong to worry. While there is no doubt to me that a fine line exists between full blown financial anxiety and actually caring about your money – it is not always a bad thing to pay attention to this stuff. I only wish I could convince more of my fellow millennials that paying attention while young is crucial!
I do firmly believe, as a long term investor myself, that the frequency in which one checks their portfolio is directly proportional to the level of anxiety they feel.
I also believe that the ultimate strategy is to make a plan, execute it, and sit back and let compounding do the heavy lifting. A watched pot never boils, and a watched portfolio just goes down (at least it feels that way).
So how many ETF’s do I need?
Well, I hate to say it, but it depends. There are hundreds (maybe thousands) of different ETF’s. Every situation is different, and the answer really depends on your desired asset allocation and risk tolerance.
You can find ETF’s that track indices like the NASDAQ or the S&P 500, you can find real estate ETF’s, you can even find alternative investment ETF’s that hold a variety of things like cryptocurrencies or marijuana stocks!
One good thing to consider is that we are already miles ahead – at least in terms of diversification – when we look at ETF’s over individual stocks. More on that below, but when it comes to diversification we need to understand two things:
The risk involved with the market as a whole. This is the stuff that you can’t diversify away (unless of course, you invest in things outside of the market). Economic cycles, geopolitical activity, these are inherent risk factors that impact essentially everything and cannot be diversified away by buying more stocks/ETF’s.
In theory, a perfectly diversified portfolio would only be left with this risk.
Think of this as company-specific risk. If 100% of my portfolio is in XYZ stock and XYZ goes bankrupt and closes its doors, I’m out of luck. Portfolio goes to 0.
If only 5% of my portfolio is made up of XYZ when it goes under, I’m not in too bad a spot, only down (at least) 5%. That is a simple breakdown of the impact unsystematic risk has.
ETF’s are a different animal.
One ETF can hold hundreds of different stocks. Talk about an easy well-diversified portfolio recipe! You could probably make the argument that there are ETF’s that exist that are sufficiently well diversified by themselves. You can buy ETF’s that mirror the entire performance of the stock market like I mentioned. That is a great example of almost exclusive exposure to systematic risk (though not 100%, more on that below).
So, the answer depends on what ETF’s you own.
One could exclusively own ETF’s that track the financial sector. While it is unlikely that the entire financial system collapses completely (maybe you are spending too much time with the crypto-hardos), it is quite possible that the sector experiences a significant amount of volatility for a time. Sectors have both systematic and unsystematic risk.
Something else to consider is that each ETF can almost be thought of as a little business. There is a fund manager, they have a job, they have a team. As almost anyone who has ever been in corporate America knows, mis-management can cause some serious issues. Doing some due-diligence on an ETF’s management team is always a good idea.
I am no expert, and I never will be one. One thing I do know is that while an ETF that tracks the S&P 500 would theoretically never cease to exist (unless America ceased to exist), poor management and deviation from the fund’s target allocation could actually cause the fund to close.
You can read about the liquidation process here. Not great if this happens.
Well can you tell me how many individual stocks I would need to have a well-diversified portfolio?
That is an excellent question. I couldn’t have thought of a better one myself. The answer is generally seen to be somewhere around 30, though there are certainly some variables that factor in and can change that number.
I don’t want to get too far into the weeds here (not a joke about those marijuana ETF’s), but to truly answer this question we would want to educate ourselves on variables like alpha, beta, correlation coefficients, Sharpe ratios and probably a whole lot more.
If you are a fan of numbers, I’d encourage you to read up on those variables.
If you are not certain that you like numbers, I am certain that you will be bored by those articles.
Also, if you find Cambridge to be a reputable source, they cite the figure of 30 individual stocks giving you a diversified portfolio. That is the figure I learned while getting my degree in Finance, so I’ll stick with it.
I hate to say it, but the answer to what it takes to build a well-diversified portfolio of ETF’s is going to be different for everyone.
I can say for sure that going the extra mile to educate yourself on how these things work is an excellent thing to do.
I hope this was a helpful dive into what diversification really is! Thank you so much for taking the time to read this!
Please do not hesitate to reach out to me with any questions, comments, or suggestions.
My contact information can be found here.
**Please note, nothing in this article is to be taken as advice of any kind. This material is for educational purposes only. Please consult a professional before making any decisions. Any decisions you make are 100% your own and should not be influenced by this educational material. Read the full disclaimer here.**