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How to diversify your portfolio by investing in ETFs

Something you’ll often hear, no matter how long you’ve been investing, is that the most important thing to remember is to always diversify. But why exactly? What are the benefits of diversification? And what even is diversification anyway?

To put it simply, diversification is all about reducing risk. As an investor, risk can either be your best friend or your worst enemy. Whenever you buy a company’s shares you’re taking on some degree of risk – risk that the company might all of a sudden go bankrupt, or another financial crisis might collapse the market, or any number of unforeseen events might occur that will wind up with you losing some, if not all, of your initial investment.

But the flipside to risk is that it’s where you generate the majority of your return from. Risk your life savings on that tech company your mate from the pub assured you would be ‘the next big thing’ and if it pays off you’ll be rich. But if it doesn’t you’ll lose everything – and you might not be heading back to the pub for another drink any time soon.

So the greater the risk, the greater the potential return – but it comes with a higher chance you’ll go bust.

But what if you decided to hedge your bets?

Maybe you’re sober enough to be sceptical of your mate’s recommendation, but still drunk enough that you secretly wouldn’t mind having a punt. So you decide to put half your money behind ‘the next big thing’ and invest the other half in a solid blue chip company. That way, even if ‘the next big thing’ tanks (as it probably will), there’s a high chance that your blue chip shares will still be close to the price you bought them at. And, just like that, diversification saved you from losing half your money.

But diversification doesn’t just help you manage risk – it also opens up new potential avenues for returns. For example, a massive drop in the oil price might hurt you if you’re invested in Beach Energy Ltd (ASX:BPT). But if you also held shares in Qantas Airways Limited (ASX:QAN), a company where the biggest expenses are fuel costs, you might find that the appreciation in the Qantas share price goes a long way to offsetting the decline in the Beach Energy shares.

If you only held Beach Energy shares you’d be kicking yourself, but because you had the foresight to add Qantas to your portfolio you might even come away still making a profit.

So now that we have an idea of what exactly diversification is, how can we ensure our portfolios are well diversified? On the face of it, diversification can seem like an expensive exercise – not many investors start out with enough spare cash to be able to build a well-diversified portfolio from day 1.

But that’s where ETFs come in. ETFs – or exchange traded funds – are investment funds that trade on a stock exchange. This allows you to buy and sell them in the same way you would ordinary shares, so there’s no minimum investment. Plus, because most are passive funds – meaning that their goal is to simply track a particular index without attempting to outperform it – management fees are low. The funds themselves are each portfolios holding a broad range of investments, allowing you to cheaply and efficiently diversify your holdings.

And there are ETFs for just about anything. SPDR S&P/ASX 200 (ASX:STW) gives you broad exposure to the S&P/ASX 200 Index, consisting of the top 200 companies listed on the ASX.

Betashares NASDAQ 100 ETF (ASX:NDQ) allows you to diversify internationally, giving you exposure to the top 100 companies on the US NASDAQ stock exchange. But there are also commodity ETFs, like ETFS Physical Gold (ASX:GOLD) which tracks the price of gold, or BetaShares Crude Oil Index ETF – Currency Hedged (Synthetic) (ASX:OOO) which does the same for crude oil.

If you are new to investing or have limited capital to invest, I would encourage you to think about putting at least some of your money into ETFs. This can quickly broaden your exposure to an incredibly vast array of asset classes, reducing your portfolio’s overall risk and opening up new opportunities to earn returns.

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Motley Fool contributor Rhys Brock has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended BETANASDAQ ETF UNITS. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.