You may want to
diversify
your portfolio to offset the potential weakness in holding a single security or group of similar securities. But it takes time — and money — to diversify a portfolio effectively by selecting a range of
subclasses
within each asset class. That's why some investors may choose ETFs or mutual funds — to supplement their portfolio of individual securities or to build the core of a diversified portfolio.
You can find ETFs based on
indexes
that track almost every segment of the market: large-, mid-, and small-cap stock, long-, intermediate-, and short-term bonds, international securities — both single country and multi-national — and dozen of sectors, from high tech to gold.
If there's a particular segment of the market missing from your portfolio, you can add it by simply purchasing shares in an ETF that tracks that segment. For example, you may own a balanced portfolio of large-cap stocks, but no small caps. Or you may have a range of domestic securities but none that are international. Instead of having to pick the right securities to create the balance you want to achieve, you can gain exposure to a wide variety of stocks, bonds, or other assets by purchasing a particular ETF. This broader diversification will help minimize the effect of any individual security that's underperforming.
Doubling up
If you own several different ETFs tracking the same segment of the market, your portfolio isn't necessarily as diversified as you may want. For instance, let's say that you own shares of the
DIAMONDS trust, which tracks the
Dow Jones Industrial Average,
and also shares of the
SPDR,
which tracks the
Standard & Poor's 500 Index.
While your portfolio would be diversified among the
large-cap
stocks represented in the DJIA and S&P 500, you may want to spread your principal among other subclasses as well — for instance,
small-cap
and non-domestic stocks — to help protect against nonsystemic risk.
Similarly, some ETFs are more diversified than others. An ETF that tracks a narrow segment of the market will obviously be less diversified than an ETF that tracks a broad-based index.
