Achieving Maximum Returns with ETFs

By Dale Gillham | Published 28 August 2018

When trading the market, one of the most important factors is to manage risk. For that reason, investors need to diversify their portfolios in order to minimise their risk in any given industry and to protect their capital. Too much diversification, however, leads to overexposure and ultimately poor returns. Let me explain...

Portfolio theory suggests that you should invest in a range of different equities to spread out your risk. This generally means you would invest in different sectors of the market and do so by investing in many different companies. I generally agree with this, however, too much of any one thing is bad and an over diversified portfolio will ultimately lead to ‘de-worsifying’ your portfolio.

Research on portfolio theory suggests that the optimal number of positions held in a portfolio is between eight and twelve. With each additional position, the reduction in specific risk is minimal, whilst systemic risk continues to rise. This leads to an over-diversified portfolio. 

It is not uncommon for me to see portfolios containing anywhere from 25 to 50 different positions, which is far more than you need. In an over-diversified portfolio, you will find that one third of the stocks will be rising, one third will be falling and the remaining third will be going sideways. This is one of the most common reasons for poor portfolio performance.

Having a properly diversified portfolio with eight to twelve positions not only reduces risk but the overall cost of constructing and maintaining your portfolio reduces, which will dramatically increase your returns.

So how do I diversify without the risk of overexposure?

Quite simply really, you either have less positions or your gain some exposure in different sectors through Exchange Traded Funds (ETFs). Let’s face it: for some finding the right company in a sector with good upside can be difficult and in many cases the timing may not be right.

A commonly overlooked alternative to stop portfolio de-worsification is to invest directly into market sector indexes. There are a number of ways in which this can be done, the most common being ETFs with other alternatives being options, futures and CFDs. 

ETFs are a great way to gain exposure to a specific industry or sector without de-worsifying your portfolio and holding too many stocks. And they are far easier to trade, as the fund will manage the investment for you. 

ETFs also significantly reduce the specific risk of holding any one company, as the fund may hold anywhere from 20-30 different companies in that sector, which allows for good exposure to a given sector. One thing to be aware of when trading ETFs, however, is to ensure that you trade the vehicle like any other stock. This is because most investors will buy an ETF in the belief that it will solve all of there problems and therefore hold the ETF regardless of whether it is trading up, down or sideways.

So what's happening in the market? Watch the video to find out.

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