Diversification Alone Is Not Enough

By Gregory S. Davis | April 07, 2009 AAA

Investors at the beginning of their investing career may recognize the importance of diversification in their investments, but knowing just how much diversification is necessary may be another story. In addition, once the decision is made in favor of one index fund consisting of 30 stocks versus another consisting of 500, not paying attention to the expenses being paid could be a costly oversight. Let's look at a few funds that offer one-stop shopping for diversification along with their annual expenses.

IN PICTURES: Eight Ways To Survive A Market Downturn

ETF YTD Three-Year Five-Year Expense Ratio
Diamond Trust
Series 1
(NYSE:DIA)
Minus 10.18% Minus 8.96% Minus 3.56% 0.17%
iShares S&P Global 100 Index (NYSE:IOO) Minus 13.34% Minus 11.07% Minus 3.85% 0.40%
SPDRS S&P 500 Index (NYSE:SPY) Minus 8.83% Minus 12.38% Minus 4.63% 0.09%

Data Through April 7, 2009

How Many Stocks Does It Take?
An individual investor going out on his/her own, in my opinion, should hold approximately 12 different stocks across multiple industries to be truly diversified. Rather than picking your 12 favorite stocks, investors can opt for diversification in the form of index funds. For example, the Diamond Trust Series 1 ETF (NYSE:DIA) tracks the performance of the Dow Jones Industrial Average, which consists of 30 large capitalization stocks like Exxon Mobil (NYSE:XOM), Microsoft (Nasdaq:MSFT) and McDonald's (NYSE:MCD). (For more, see An Introduction To Diversification and The Importance Of Diversification.)

Take It Up A Notch To 100
The iShares S&P Global 100 Index ETF (NYSE:IOO) has approximately 107 holdings. While it offers some of the same holdings found on in the DIA fund, the IOO fund has additional multinational brands like the Switzerland-based chocolate giant Nestle, France-based oil and gas services company Total SA (NYSE:TOT), and Spain's telecommunications company Telefonica SA (NYSE:TEF).

Why Stop At 100 When You Can Go To 500?
The SPDRS S&P 500 Index ETF (NYSE:SPY) consists of large companies that investors can also find in the DIA index, but the fund goes a step further by adding additional companies like wireless telecommunications provider Qualcomm (Nasdaq:QCOM) and medical device maker Medtronic (NYSE:MDT). The SPY fund also has the highest percentage of assets focused on the services sector, led by areas including healthcare and financial services, while the DIA and IOO funds lean more toward manufacturing.

Final Thoughts
Goals for investors must include building a diversified portfolio along with keeping an eye on maintaining low expenses. All of the ETFs mentioned above are bargains compared to mutual funds with average expenses of 1.4% of assets. Holding an index of funds with more than 30 stocks doesn't appear to offer any additional benefit in terms of the three-year and five-year returns. However, choosing a fund with low fees, when the returns are so close, could lead to a more positive result for investors using these funds to diversify their initial investment.

For further reading, see Don't Judge An Index Fund By Its Cover and The Lowdown On Index Funds.

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