Diversification is often touted as one of the most important aspects of investing. But what exactly is diversification and how does one go about diversifying?

Fortunately for investors, listed funds such as exchange-traded funds (ETFs) and listed investment companies (LICs) make the job of diversification much easier than investing in individual securities like shares and bonds.

ETFs & LICs already have diverse holdings, but there are some common traps you can fall into without realizing it.

Key Takeaways

• Investing in listed funds like ETFs & LICs makes the job of diversification much easier than investing in individual securities like shares and bonds.

• Diversification is spreading risk across different types of assets, including shares, bonds, and cash.

• Many investors think that putting money into different ETFs & LICs is enough diversification, but different is not always the same thing as diverse.

• Diversification allows you as an investor to accomplish your primary task, which is to grow financial wealth over time; at the same time, you are minimizing risk by reducing volatility.

What Is Diversification?

Put simply, diversification is spreading risk across different types of assets, including stocks, bonds, and cash.

Diversification is important, because having all your eggs in one basket can leave you vulnerable to sharper market fluctuations, whereas diverse portfolios spread risk and invest in different types of businesses at the same time.

Diversification Advantages With ETFs & LICs

Diversification is one of the many advantages of investing in listed funds and it can help an investor in two ways: instant diversification and portfolio diversification in multiple fund categories.

First, the beauty of ETFs & LICs is that you can invest a few thousand dollars in one fund and obtain instant access to a diversified portfolio. Otherwise, in order to diversify your portfolio, you might have to buy many individual securities. This would expose you to more risk than you would find in listed funds.

For example, if you have a typical portfolio of individual shares that includes 20 to 30 securities, this portfolio is not nearly as diversified as one ETF that tracks the ASX 200, which includes 200 securities! In other words, a listed fund allows an investor to diversify into many different shares in a simpler and more cost-effective way.

Sometimes, when it comes to diversification, it’s not good enough to simply own many different shares. For example, you might own 100 shares within an ETF, and those 100 shares are in the financial sector (a sector ETF). It is more than likely that as the financial sector moves up and down, so does the value of your ETF.

That brings us to the second point. An ETF also allows for diversification between various styles, sectors, countries, and just about any combination of security types you can imagine. You can either buy an ETF that is broadly diversified (such as a diversified ETF - perfect for beginners), or you can buy a portfolio of ETFs across various sectors and create your own diversification.

Different Is Not Always the Same as Diverse

While ETFs & LICs are great tools for diversification, you might also be caught up in a common mistake. Many investors think that putting money into different funds is enough diversification, but different is not always the same thing as diverse.

For instance, you may invest in two different ETFs, but it does no good if they both have the same holdings. You are not actually diversifying because if something affects the securities in one fund, it will also affect the other fund.

To truly diversify your portfolio, you need to invest in a fund that does not share a large proportion of holdings with your other funds. Consider which holdings the fund you're investing in has (or the index it tracks) and try to spread your money throughout different types of fund categories (or just stick with a single diversified ETF).

Risk, Reward, and Diversification

In summary, ETFs & LICs allow for diversification between many different shares while also allowing for diversification between various sectors, styles, etc. ETFs & LICs can also invest in other assets, such as bonds, cash, or commodities like gold and other precious metals.

And this diversification allows you as an investor to accomplish your primary task, which is to grow financial wealth over time, while at the same time minimising risk by reducing volatility.

If you'd like to get started or learn more about diversified investments, checkout the most popular ETFs & most popular LICs on our platform for some ideas!