Why it’s important to diversify your investments and how to go about doing it

While financial experts recommend diversifying your portfolio into stocks and bonds as well as other investments in order to reduce risk, it can seem difficult to do.

One alternative is to use exchange-traded funds (ETFs) to invest in a multitude of stocks, bonds and properties.

WHAT DIVERSIFICATION MEANS

Diversification of your portfolio refers to putting your assets into a variety of different types of investments.

One part is investing in different classes of assets, such as stocks, bonds and real estate, rather than just one.

While you may not gain as much if stocks soar and bonds don’t, for instance, you will also be less affected by a negative event in one sector, such as a property market downturn. 

Diversification also refers to investing in more than one asset in each category.

Rather than putting all your money allocated to stocks into shares of one or two companies, for example, you would diversify by investing in at least about a dozen companies.

If your entire portfolio is invested into just DBS bank and Singtel shares, for example, a drop in the value of one of the companies would have a large negative impact on your portfolio, regardless of how good the companies are.

WHY YOU SHOULD DO IT

The reason to diversify, investment adviser Fidelity explains, is to help reduce the volatility of your portfolio, mitigate risk and potentially reduce the number and severity of “stomach-churning ups and downs”.

While some investors may expect that diversification will improve the yield on investments, Fidelity notes that the primary goal of diversification is not to maximise returns and it does not guarantee against a loss. Instead, its primary goal is to limit the impact of volatility. 

WHY EXCHANGE-TRADED FUNDS ARE AN OPTION

One of the easier ways to diversify is to put your investments into ETFs.

ETFs are set up to follow assets such as a stock market index or a portfolio of bonds and are traded on a stock exchange. The Nikko AM STI ETF, for example, enables you to buy into a portfolio that tracks all 30 companies in the Straits Times Index by purchasing a single ETF.

DBS explains that ETFs are exposed to a range of asset classes, so Singapore investors can achieve “multi‐asset diversification”, which is essential amid uncertainties that have made investing more difficult.

“ETFs that track indices or a basket of assets such as stocks are generally — but not always — less risky as compared to, say, a single stock.”

Investment advisory firm Vanguard similarly says that ETFs are “a simple and low-cost way to diversify a portfolio across asset classes, investment strategies and geographic regions”. You can invest in ETFs to get broad exposure within a specific type of assets such as stocks, and use them to reduce volatility and help smooth investment returns.  

Another benefit of using ETFs for diversification rather than mutual funds or unit trusts is cost.

The fees for most ETFs tend to be much lower than mutual funds, investment manager Blackrock said, which means more money gets put to work for you.

As one example, ETF strategist Nicholas Vardy at investment advisory The Oxford Club found that the returns on the Vanguard 500 Index fund over the past five years totalled about 52 per cent, while the return on the Rydex S&P 500 Fund — a mutual fund which should invest in the same S&P 500 stocks — was about 38 per cent.

“The return on these funds should be identical,” he said. “The only real difference? The Vanguard 500 Index Fund charges a fee of 0.04 per cent (a year) compared with the Rydex S&P 500 Fund's 1.55 per cent.”

WHICH FUNDS TO TAKE UP FOR BETTER OUTCOMES

Diversifying your investments using ETFs means doing more than just buying one ETF. Even if you own 10 ETFs, for example, you would still lack a diversified portfolio if they’re all one type, such as stocks.

Instead, you should buy ETFs in multiple sectors, such as Singapore stocks, global stocks and bonds. When you invest in several sectors, your total investment returns will usually be more stable. If one asset class drops, the others may well remain constant or rise.  

To create a diversified investment portfolio, you can start with ETFs for stocks, which offer the potential of higher returns. Adding a Singapore or international bond fund will help you diversify. Even just having two ETFs can create some diversification for investors who want simplicity.    

In Singapore, investors can choose from more than 50 ETFs that track STI stocks, bonds, real estate investment trusts (Reits) or indices for stock markets anywhere from Indonesia to Russia.

DBS notes that using a regular savings plan to purchase ETFs enables dollar cost averaging that smooths out changes in prices. Dollat cost averaging means that you buy into the ETFs at regular intervals with the same dollar amount — buying fewer shares when prices are high and more shares when prices are low. Buying at both high and low points consistently, over time, you have a portfolio of shares in the ETF that have an average share price which moderates your risks.

Investing using ETFs for the Straits Times Index, Singapore government bond ETFs, S‐Reits and Singapore Investment Grade Corporate Bond ETFs can offer exposure to a variety of sectors.

A multitude of investment advisory portals in Singapore, as well as brokerage firms, can provide insights into which ETFs to purchase. 

While diversification may have been difficult in the past, using ETFs makes it easy now and can allow you to sleep better due to less volatility in your investment portfolio.