In my previous article, Getting Back To Basics, I explained why long-term investing is a viable strategy for new investors and provided numerous examples of basic investment fundamentals. This week, I aim to build upon those fundamentals by introducing two more investment concepts, diversification and index investing, while also describing how exchange traded funds (ETFs) help investors mitigate risk.

What Is Diversification?

Diversification is a risk management technique that all new investors should apply to their portfolios. The goal of diversification is to create a wide variety of holdings within a portfolio in order to limit risk, and yield potentially higher returns. How does diversification achieve this? The rationale is actually quite simple. By holding a mix of different securities, the positive performance of some stocks will, most likely, outweigh the negative performance of others. Furthermore, this mix of stocks and bonds does not simply entail holding identical assets of different companies, but rather a collection of different forms of securities themselves. A diversified portfolio may contain a number of large cap stocks (i.e. Netflix (NFLX) and Microsoft (MSFT)), mid-cap stocks (i.e. Groupon (GRPN) and Rite Aid (RAD)), small cap stocks (i.e. Plug Power (PLUG) and FuelCell Energy (FCEL)), foreign stocks, emerging market stocks and bonds, corporate bonds, and real estate (among countless others).

An example: Say you own securities in American, Chinese, and Brazilian companies, but that the U.S. economy is “struggling,” while both the Chinese and Brazilian economies experience vast growth. Hypothetically, the gains from these foreign, emerging market holdings should offset the losses of your domestic American holdings. By “not putting all of your eggs in one basket,” you eliminate a significant amount of risk and can generate decent returns.

Plain and simple, diversification is a proven risk-averse strategy that provides security to the investor (at the expense of a reduced ROI).

What Is Index Investing?

An index is a collection of stocks chosen to represent the performance of the market as a whole. Indices allow investors to monitor the performance of different sectors and provide an additional source of important financial information. The most relevant American indices include the Dow Jones Industrial Average, NASDAQ Composite, and S&P 500 (unfortunately, many individuals who are unfamiliar with investing often mistake these indices for the actual “stock market”). The Dow Jones tracks the performance of 30 major American companies, such as Boeing (BA) and Nike (NKE), the NASDAQ tracks all 3,000+ companies traded on the NASDAQ exchange (with a particular emphasis on Tech), and the S&P 500 tracks 500 large cap American companies (all at the top of their respective sectors). Obviously indices are incredibly helpful, but imagine a prospective investor who wants to create a portfolio that tracks the performance of only the S&P 500… the costs would be astronomical. This is where index funds come into play.

An index fund allows investors to purchase shares of a single security that mirrors an entire index. By buying into an index fund, investors expose themselves to a large variety of holdings. They also simultaneously diversify their portfolios, as index funds are purchased as a single security. Additionally, index funds are also extremely cost efficient because they are the result of pooled investor resources; thus, no individual need incur a massive expense. Lastly, unlike actively managed mutual funds, which are often associated with high commission rates, index funds usually have lower expense ratios for investors.

What Are Exchange-Traded Funds; Should They Be Part Of My Portfolio?

An exchange-traded fund is arguably the best way to individually benefit from index investing. Exchange-traded funds hold a number of assets (or stocks) that reflect sector performance or promote growth. They are also traded like stock, which makes ETFs easy to buy and sell. Furthermore, ETFs come in all varieties, which allows investors greater freedom in selecting where to place their money. Such ETF examples include the Vanguard FTSE Emerging Markets ETF (VWO), which tracks and reflects the performance of stocks issued by foreign companies in the FTSE Emerging Markets Index, and the iShares NASDAQ Biotechnology Index Fund (IBB), which tracks and reflects the performance of biotechnology and pharmaceutical stocks listed on the NASDAQ. Lastly, brokers can even invest in exchange-traded commodity funds, currency funds, real estate funds, and fixed-income funds.

Exchange-traded funds are particularly useful for young investors. Since they are composed of a number of different assets, ETFs not only help you diversify and limit risk, but they also reduce the amount of research you must conduct. Instead of researching individual companies, you can instead pick and choose sectors, or strategies, that you believe will be profitable in the future (remember, I advise that you hold your securities for the long-run).

Think of ETFs as prepackaged, diversified portfolios that can be purchased in the same manner as common stock.