Some traders use exchange traded funds to get exposure to entire sectors while avoiding single-stock risk, while buy-and-hold investors often tap ETFs as building blocks for a diversified portfolio.
Risk management is extremely important in fast, volatile markets. ETFs, which are baskets of securities that trade like individual stocks, offer low fees, transparency and daily liquidity.
Diversification is an important investing principle designed to reduce risk within a portfolio of investments, by allocating to a range of various asset classes. ETFs have made diversifying a portfolio even easier. [What is an ETF? Premiums and Discounts]
ETFs are a basket of stocks tracking an index made up of one sector or asset class, already utilizing a built-in diversification method. The key is to look at the ETF composition and the actual companies that are holdings, because the title of the ETF can be misleading. Also, investors can be aware if they are heavily weighted to one company by taking this step, and be on the lookout for portfolio overlap. [What are ETFs?]
The bond market is an important key to a diversified portfolio because it has a low correlation to the broad market, or moves to its own beat, and does not follow the same general direction of the stock market. This type of diversification is important and can protect a portfolio.
Another way to diversify is through the currency and commodity markets. Currency and commodity ETFs are a boon to investors because they give individuals access to market segments once off-limits. For instance, the simplicity of a commodity ETF has made investing in gold simpler because there is no physical delivery involved. [Investors Look to Commodities ETFs for Diversification]
It is important to realize that a certain amount of risk is involved whenever an investor puts capital into markets. By allocating across several sectors, asset classes, and the bond market, losses from market movements can be mitigated. The goal is risk management, rather than eliminating risk.
Tisha Guerrero contributed to this article.