Are your investments properly diversified?
It’s super important that they are! Luckily, it’s not complicated.
Welcome back to another Ask Me Anything Wednesday! This week we’re digging into an important investing question.
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“How many index funds does it take to be properly diversified?”
Short answer:
As long as your index fund invests in companies from multiple sectors, you could technically be well diversified with one or two funds depending on your risk tolerance.
Nuanced answer:
Before we tackle answering the question, it’s important you understand what it means to be properly diversified.
Diversification is a critical part of a well-balanced investment portfolio, but it’s a simple concept: Don’t put all your eggs in one basket. If all your money is invested in one company, then it’s at a much greater risk compared to investing in multiple companies. It’s all about mitigating your risk.
(I’m about to name real companies for the sake of illustrating a point. This is not me giving you investing advice!)
Lisa is just starting to invest. She decides to invest in something with which she’s familiar and she’s been on Zoom a lot lately. Lisa buys three shares of Zoom stock. Lisa is not diversified at all. Every penny she has invested is all in one company. The next day, Lisa buys three shares of Apple. Okay, great, Lisa is a little bit diversified because there are two different companies in her investment portfolio (Zoom and Apple) – but she’s still not well diversified because both of those companies are in the same sector, technology.
Does your brain hurt a little yet?
When we talk about “diversifying investments” it’s not just about owning stock of multiple companies. It’s also about owning stock in different sectors of the stock market. Sectors represent the type of business a company does. For example, Zoom is technology, Quest Diagnostics is Healthcare, Verizon is communication services, Coca-Cola is consumer staples and Exxon is energy. There are 11 sectors, but you get the point. You don’t need to know all the sectors represented in the stock market, but you do need to make sure your investments are not all bundled in one or two sectors.
There are times when just one or two sectors experience a tumble and stock prices go down, but other sectors aren’t impacted as much. That’s why diversification across both companies and sectors is important. It’s also why individual stock picking is not the best option for the average retail investor (which you and I both are!).
That brings us to the actual question at hand: “How many index funds does it take to be properly diversified?”
Index funds, mutual funds, and exchange-traded funds (ETFs) are praised for the fact that these products provide built-in diversification. It’s built-in because you’re investing in many companies all at once. (Technically an index fund is often a type of mutual fund, but I’m separating them out for the sake of this discussion.)
What are those, you might be wondering, and how do they magically diversify my money?
An index is a way to measure the stock market’s performance by looking at a statistically significant portion of the stock market. For example, the S&P 500, which is an index of stocks issued by 500 large, publicly-traded companies. The Dow Jones Industrial Average is another commonly referenced index and it tracks the 30 prominent, blue-chip companies.
An index fund mirrors an index.
Putting money in an S&P 500 index fund means your dollars are invested in companies that are in the S&P 500. It gets a little technical about whether you own shares in all the companies – but the point is that your fund’s performance will closely mirror the performance of the index it’s tracking.
Index funds, mutual funds and ETFs have nuances that make them different from each other, which could be its own newsletter, but all of them offer an easy way to diversify your investments.
All of this leads up to truly answering the question at hand!
You don’t need to own many index funds (or ETFs or mutual funds depending on your preference) to be well diversified. In fact, some people will say you just need one: Total Stock Market. It’s not a damaging strategy that will ruin your investments, but personally, I don’t agree.
Partly, because it depends on where you are in your investing journey and how much risk you want to put on your money. If you're getting closer to when you plan to access some of your invested money (like retirement or selling to use for a down payment), then you might want less risk and have a fund that also invests in bonds (more conservative) instead of just stocks. Another factor ties into diversification. I like to own some international stock to diversify outside of just America.
Whatever you pick, just make sure that your funds are actually spread out across sectors. If you pick three index funds or ETFs that sound good, but are overweighted in a certain sector (like tech) you still aren’t as diversified as you think.
How can you tell?! You can click “overview” when researching a fund on a brokerage’s website (e.g. Vanguard, Fidelity, Charles Schwab) and it should break down what percentage of the fund is invested in each sector. This is sometimes called Portfolio Composition.
*Phew* That was a lot of information and it’s totally okay if you’re walking away from this asking more questions. Drop your question into the comments below and you might see it answered in a future newsletter!
To recap:
You need to invest in more than a few companies.
You need to invest across different sectors.
Index funds, mutual funds, and ETFs offer easy diversification.
It’s okay to only hold a few index funds/ETFs, but you want to make sure those aren’t all overweighted towards one sector.
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