How to Build a Diversified Portfolio Using ETFs?

Creating a well-diversified portfolio is crucial for every investor. It helps mitigate risks associated with different investment instruments and ensures that your financial future remains stable even during market fluctuations. Traditionally, stocks and mutual funds have been the go-to options for building wealth. Stocks offer direct ownership in companies, allowing you to benefit from capital appreciation, while mutual funds pool resources to provide professional management and diversification.

However, both vehicles have limitations. Stocks require extensive research and can be highly volatile, whereas mutual funds often entail higher expense ratios and limited flexibility. Enter ExchangeTraded Funds (ETFs), a revolutionary investment avenue that combines the best features of stocks and mutual funds. ETFs offer the flexibility and real-time trading of stocks along with the diversification benefits of mutual funds, and they also have the potential for significant growth.

In this blog, you will learn how you can use ETF to build a diversified investment portfolio and achieve your financial goals. We have also comprehensively covered the prerequisites and tips for successful ETF investing. Keep reading to feel fully informed about ETFs. 

What are ETFs?

Before diving into the process of building a diversified portfolio using ETFs, it’s essential to understand what they are. 

An Exchange-Traded Fund (ETF) is a type of investment vehicle traded on the stock exchanges, similar to individual stocks. Unlike mutual funds, which are priced once daily, ETFs can be bought and sold throughout the trading day. Each ETF represents a basket of securities, such as stocks, bonds, commodities, or even a mix of assets.

An ETF tracks the performance of a specific index and allocates your money to the assets within that index in the same proportions. This eliminates human bias and allows you to mirror the index’s returns. For instance, an ETF mirroring the Nifty 50 index invests in the top 50 companies listed on the National Stock Exchange (NSE).

Why Use ETFs to Diversify Your Portfolio?

Diversification involves spreading your investments across various asset classes, sectors, and geographies to minimise risk. Here’s why ETFs are an excellent tool for this:

Broad Market Exposure

ETFs provide exposure to a wide range of assets. They help you invest in multiple sectors, markets, or even countries, a key aspect of diversification.

Cost-Effective

ETFs are cost-effective investment vehicles. They come with lower expense ratios than actively managed mutual funds. It means more of your money works for you.

Flexibility

ETFs offer the flexibility of stocks. You can buy and sell them anytime during market hours and have complete control over your portfolio.

Lower Investment Required

You don’t need a high capital to invest in ETFs. You can start by buying even a single unit of an ETF, costing around a hundred rupees.

Easy Accessibility

Thanks to a range of Demat app, you can easily invest in ETFs from the comforts of your home or office. 

Transparency

Most ETFs are transparent and disclose their holdings daily. This ensures you always know what you’re investing in.

Steps to Build a Diversified Portfolio Using ETFs

Now comes the time to address the elephant in the room. Below are the steps to build a diversified portfolio using ETFs:

Define Your Investment Goals

The first step to building a diversified portfolio is clarifying your investment objectives. Are you investing for buying a house, building a retirement corpus, or for your child’s higher education? Your investment goals will determine the type of ETFs you should include in your portfolio.

For instance, if you’re investing for long-term capital growth, equity ETFs might be a good choice. In contrast, if you’re seeking stability and regular income, you can consider investing in bond ETFs. Lastly, if you’re looking to hedge against inflation, commodity ETFs like gold ETFs can be helpful.

Assess Your Risk Tolerance

Analysing your risk tolerance is very crucial before investing in any instrument. It varies from person to person. Some investors can handle market volatility, while others prefer safer options. Your risk appetite will guide your allocation across different asset classes.

For example, if you can tolerate high risks for steady returns, you can allocate a large chunk of your investment to equity ETFs. Similarly, you can focus on bond ETFs if you’re a risk-averse investor.

Choose The Right ETFs

With hundreds of ETFs available, choosing the right ones is crucial. Your investment goals and risk-taking capacity must guide you through the process. Below are the different types of ETFs you can choose from:

Equity ETFs: Consider equity ETFs for exposure to the stock market. These ETFs track major stock market indices, such as the Nifty 50 or the Sensex.

Sectoral ETFs: Sectoral ETFs are good investment options if you are bullish on the growth of a specific sector, such as technology or healthcare. These ETFs track the performance of stocks belonging to the same sector or industry.

Bond ETFs: Bond ETFs are ideal for those seeking stable returns and lower risk. These ETFs invest exclusively in government and corporate bonds.

International ETFs: Investing in ETFs that track international indices can help you diversify geographically.

Thematic ETFs: These ETFs focus on emerging trends, such as ESG (Environmental, Social, and Governance).

Create a Well-Balanced Portfolio

Based on the selected ETFs, build a well-diversified and balanced portfolio. The key is to include a mix of assets tailored to your goals and risk tolerance. There are various types of ETFs available as mentioned above, you can choose as per your investment goals and risk appetite.

Rebalance Regularly

Market movements and other factors may cause your portfolio’s asset allocation to drift from its original plan over time. Your financial goals may also change with age. Rebalancing your portfolio from time to time helps maintain your desired risk-reward ratio. For example, as you come closer to achieving your investment goals, you can start selling off your equity ETFs and reinvesting the proceeds in bond ETFs.

Keep Monitoring

Keep monitoring your portfolio’s performance to ensure you are on the right path to achieving your financial goals. Stay updated on market trends and economic developments to make informed decisions.

Tips For Successful ETF Investing

Below are a few tips that can help you succeed while investing in the ETF:

Start Small: Begin with a small amount to familiarise yourself with ETFs.

Focus on Liquidity: Choose ETFs with high trading volumes to ensure easy buying and selling.

Watch Expense Ratios: Opt for ETFs with low expense ratios to maximise returns.

Avoid Over-Diversification: While diversification reduces risk, holding too many ETFs can dilute returns and complicate management.

Conclusion

Exchange-traded funds are suitable tools for portfolio diversification. By defining your goals, assessing your risk tolerance, and strategically selecting ETFs, you can create a robust portfolio tailored to your needs.

All you need to do is download a trading app and open Demat account. HDFC SKY, with a user-friendly platform and robust customer support, can help you embark on your journey toward smart investing.