Are ETFs the Best Way to Diversify?

You’ll often hear that it’s important to maintain a diverse portfolio if your goal is to grow long-term wealth. A diverse portfolio could also help minimize losses during a stock market crash.

You have different options when it comes to assembling a diverse investment mix. You could buy a whole bunch of different stocks from various market sectors, or you could load up on ETFs, or exchange-traded funds.

ETFs are publicly traded funds that allow investors to buy many stocks at once. They’re similar to mutual funds in that they consist of a bunch of different companies, but they’re different in that their share price can change numerous times a day, whereas mutual funds are priced once daily and also don’t trade on major exchanges.

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ETFs are commonly regarded as a great diversification tool. But are they your best option for diversifying? It depends.

The pros of ETFs

ETFs really do take the guesswork out of diversification. Compared to individual stocks, there’s a lot less research involved — which could also lead to a lot less stress.

Also, compared to mutual funds, ETFs charge much lower fees, known as expense ratios. This makes them a more cost-effective investment. However, when you own stocks, you don’t pay any ongoing fee to own them. And even low fees could add up over time.

The cons of ETFs

It’s good to own a diverse mix of investments, but you may want a say in what those are. Now you can obviously choose one ETF over another. But you can’t choose what investments your ETF consists of.

When you buy individual stocks, you get complete control over your portfolio. If you’re skittish about a certain market sector, it’s your choice to opt out of it, whereas a broad market ETF may not allow you to do that.

Also, when you buy ETFs, you’re not setting yourself up to beat the market. Now that may not be a problem for you. But if you’re hoping to generate higher returns, you’ll need to strategically choose the right mix of stocks.

Also, if your goal is to generate a lot of dividend income, ETFs may not be the best way to do it. Granted, most ETFs pay dividends, and there are specific dividend ETFs you could look to own. But if you’re hoping to secure a steady, generous stream of dividend income, you may do better by loading up on companies with higher-than-average dividend yields (though to be clear, you shouldn’t just focus on a stock’s dividend yield when deciding whether to add it to your portfolio or not).

What’s the right call?

The primary benefit of using ETFs as a diversification tool is that it’s easy. And there’s also less pressure on you as an investor, because you don’t have to worry about choosing the wrong stocks.

If your goal is to assemble a diverse portfolio, ETFs can get you there. But you may want to take a hybrid approach that includes both ETFs and individual stocks. Doing so could really give you the best of both worlds.

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