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FINANCIALLY AESTHETIC · GUIDE 30/37
DIVERSIFICATION, INDEX FUNDS, ETFS & ASSET ALLOCATION
FA-6.3 · Investing & Wealth Building
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BEFORE YOU INVEST
Owning more tickers isn't automatically diversification; what matters is the risk underneath them.
Why Diversify?
This is the first piece of advice given to any saver: “Don’t put all your eggs in one basket” - that is, don’t invest all your savings in a single investment to reduce the risk of a losing investment. But while the principle is simple, implementing effective diversification, in all its forms, is not so easy.
In an uncertain world, proper diversification provides a protective foundation for your savings against unexpected events. To reduce the risk of your investments, you need to combine investments that do not perform the same way at the same time.
Diversifying is, of course, a matter of prudence, but above all, it gives you the best chance of achieving your long-term savings goals while earning returns higher than those of risk-free savings.
Diversification: A Boon for Savings
Diversifying your savings stimulates them. This is sometimes referred to as optimization: while managing the risk level, you increase the chances of achieving satisfactory returns and thus reaching your goals.
No one can predict the future, and the history of financial markets is full of unexpected developments. To benefit from economic growth - whether in Europe or other regions - it is important to invest across different geographic areas or sectors and to maintain these diversified investments over time. In this way, this diversified portion of your savings will perform in line with average market trends.
Liquid and guaranteed savings are not entirely risk-free. Financial assets held entirely in guaranteed investments are at high risk of losing their real value over the long term due to inflation. Diversification across financial markets helps increase your chances of preserving your purchasing power.
Although less volatile than equity investments, real estate is not a guaranteed investment. Savers whose assets consist primarily of real estate would reduce this risk by diversifying their investments into financial markets, whose values do not move in the same way as real estate.
The Principle of Asset Allocation
Asset allocation involves distributing one’s investments across different asset classes, such as stocks, bonds, and cash. The decision regarding asset allocation is a personal one. The most appropriate allocation changes at different stages of life, depending on one’s investment horizon and risk tolerance.
Investment Horizon. The investment horizon refers to the number of months, years, or decades you plan to invest over to achieve your financial goal. Investors with a longer investment horizon may feel comfortable with riskier or more volatile investments. Those with a shorter horizon may prefer less risky or less volatile investments.
Risk tolerance. Risk tolerance is the ability and willingness to lose some or all of one’s initial investment in exchange for potentially higher returns. In general, as investment risks increase, investors seek higher returns to compensate for taking on such risks. An investor with a high risk tolerance is willing to risk losing money in order to achieve potentially higher returns. An investor with a low risk tolerance favors investments that aim to preserve the initial investment.
The appropriate level of diversification depends not only on the investor’s profile but also on their investment horizon. If the goal is to prepare for retirement, a cautious investor under the age of 35 can allocate a large portion of their retirement savings to equity investments. A young, risk-tolerant investor could even invest all of their retirement savings in equity investments. In this case, they must not withdraw these invested savings before the intended maturity date - that is, retirement - for example, to finance the purchase of their principal residence. Hence the need to invest only money that one is certain will not be needed sooner, in order to fully benefit from the long-term return potential of stocks.
Investments in stocks require a calm outlook on the economic future. The relationship is simple: despite sharp fluctuations, stock prices tend to rise in line with corporate earnings growth, which is itself broadly correlated with economic growth.
Rebalancing Your Portfolio
Over time, some investments grow faster than others. This can cause your holdings to deviate from your investment goals and alter your portfolio’s risk level. To return your portfolio to its original asset allocation, you may need to rebalance it.
For example, you might start with 60% of your portfolio invested in stocks, but see that proportion rise to 80% due to market gains. To restore your original asset allocation, you may need to sell some of your stocks and/or invest additional funds in other asset classes.
Shifting money out of an asset class when it is performing well and/or into an asset class that is underperforming is not necessarily easy. But it can be a wise decision. By reducing current “winners” and/or adding more current “losers,” rebalancing forces you to buy low and sell high.
Some financial experts advise rebalancing at regular intervals, such as every six or twelve months. Others recommend rebalancing when holdings in an asset class increase or decrease by more than a predetermined percentage. In either case, rebalancing generally works best when done relatively infrequently.
What Is Diversification?
When determining your asset allocation, you should consider diversification - the practice of spreading your money across different investments to reduce risk. Diversification is a strategy that can be summed up as: “Don’t put all your eggs in one basket.”
One way to diversify is to spread your investments across different asset classes. Market factors or conditions that cause one asset class to underperform may improve the returns of another asset class. Investors invest in various asset classes in the hope that if one loses money, the others will offset those losses.
You can also achieve better diversification by spreading your investments within each asset class. This might mean holding a number of different shares or bonds and investing in different industry sectors, such as consumer goods, healthcare, and technology. That way, if one investment or sector underperforms, you can offset it with other holdings that are performing well.
What is an ETF (index fund)?
An ETF (or tracker) is an investment that seeks to track the performance of a stock market index (such as the CAC 40 or Nasdaq). Like any other collective investment, ETFs have both advantages and risks.
An ETF (Exchange-Traded Fund), also known as a tracker, is an index fund that seeks to track the performance of a stock market index - typically a basket of stocks - as closely as possible, whether the market is rising or falling. An ETF allows investors to achieve diversification in a single transaction without needing to purchase, one by one, the stocks of the companies that make up the ETF’s benchmark index.
ETFs are investment funds issued by licensed asset management companies. However, unlike other funds (FCPs, SICAVs, etc.), they are continuously traded, meaning they can be bought or sold throughout the day. As with stocks, you place your trade order with your financial institution and control the price of the order. Like other funds, they have a Key Information Document (KID) in which investors can find essential information about the investment (risk level, fees, etc.).
As funds, ETFs comply with the safety regulations for collective investments (including securities guarantees, diversification, and the presence of a custodian separate from the manager to protect your assets in the event of the management company’s bankruptcy, etc.).
Why Invest in ETFs?
ETFs, like traditional funds and SICAVs, allow you to invest in financial markets, enabling you to diversify your savings across unsecured but potentially higher-yielding investments.
Why invest in an ETF rather than a traditional fund? First and foremost, to invest in a market “passively” - that is, to track, no more and no less, the performance of the chosen benchmark index.
ETFs also have lower fees - often less than 0.5% per year - compared to a traditional “actively managed” fund, whose fees exceed 1% per year, or even 1.5% for certain fund categories. This is because these actively managed funds employ more extensive analytical resources to select the securities in which the fund invests.
A savvy investor knows that when it comes to financial investments, it is essential to diversify effectively to reduce the overall risk level of their portfolio. ETFs can therefore serve as a “turnkey” solution.
The Different Types of Indices and ETFs
These are the simplest ETFs and the ones most commonly used by savers. Market index ETFs track the performance of stock indices (such as the Paris CAC 40, one of Wall Street’s flagship indices, the Dow Jones, or the German DAX 30), sector indices (for example, the energy or bank sectors, etc.), or bond indices. Among the indices most commonly accessible via an ETF are the Euro Stoxx 50 (which comprises the 50 largest listed companies in the euro area), the MSCI World (the largest listed companies on major Western stock exchanges), and the S&P 500 (the 500 largest U.S. stocks).
Strategy-based index ETFs track the performance of more sophisticated indices, such as an index that favors companies paying high dividends or stocks with low volatility. The benchmark index is derived from a primary index that is generally better known. It maintains a fairly similar composition but differs by weighting the securities in that index differently. As a result, this type of ETF is intended for more experienced investors seeking more sophisticated investment strategies.
In recent years, it has become possible to choose actively managed ETFs - similar to traditional mutual funds and SICAVs - with an independent portfolio manager who makes investment decisions. Generally, this type of ETF aims to outperform its benchmark index.
A physically replicated ETF invests directly in the stocks or bonds that make up its benchmark index. This replication can be full or partial, depending on the number of securities in the index. Physically replicated ETFs are the most common.
A synthetically replicated ETF does not directly hold the securities that make up its benchmark index. Instead, it enters into a financial contract (a swap) with another financial institution (usually a bank), which holds the securities on its behalf.
Like traditional funds, ETFs can distribute or reinvest the income they generate. A distribution ETF pays investors the dividends from the companies that make up the benchmark index. A reinvestment ETF, on the other hand, automatically reinvests these dividends: this allows investors to benefit from the growth in earnings of the companies included in the benchmark index and from the “snowball effect” (compound interest).
Risks and Fees Associated with ETFs
While ETF fees are generally lower than those of “traditional” funds, there are still several types of fees to be aware of:
- brokerage fees, charged when buying and selling shares, just as when buying or selling stocks;
- custody fees, as with stocks;
- management fees, which are deducted from the ETF’s returns.
The main risk of an ETF investment relates to fluctuations in the market index it tracks: if the index falls, your portfolio will fall by the same proportion - or even more sharply if you have chosen ETFs with leverage. You could therefore lose all or part of your invested capital.
For ETFs denominated in foreign currencies (U.S. dollars, pound sterling, etc.), you must factor in foreign exchange risk: fluctuations in the currency’s value are added to those of the index itself.
Another risk is that the ETF’s performance may deviate from that of its index (known as tracking error), as replicating an index is not always easy, especially for indices with a large number of components.
Investors should also be cautious with more “exotic” ETFs (small-cap stocks, underdeveloped emerging markets, thinly traded bonds, highly specialized sectors, etc.). These types of ETFs may appear highly liquid because they are continuously traded on a major stock exchange, even though the securities comprising the index they are trying to track are themselves illiquid. As a result, the ETF may have difficulty buying or selling the securities and incur significant transaction costs. Its value may then deviate from the index’s theoretical value.
How to Invest in ETFs
You can buy ETF shares through a financial institution such as a bank or an online broker. To be authorized to offer you ETFs, the institution must be registered as an investment services provider (PSI) in the Regafi registry.
ETF shares can be bought or sold on the stock exchange at any time, just like stocks. The types of orders are the same as those used for stocks.
To buy or sell ETF shares, you must have a standard securities account and/or a PEA for ETFs accepted under the PEA (which must be invested 75% in shares of European Union companies). ETFs may also be eligible through other investment vehicles, such as unit-linked life insurance or employee savings plans, provided the plan in question has selected them.
How to Learn More About an ETF
Before investing in an ETF, it’s difficult to research each of the companies that make up its benchmark index! The best approach, therefore, is to take a broader view and look for information on the economy in general - and specifically on the industries represented (for example, healthcare, luxury goods, etc.) or the target geographic region (Europe, emerging markets, etc.). Don’t hesitate to cross-check your sources and seek out different perspectives on the growth prospects of a geographic region or industry sector to form your own opinion.
The name of the index being tracked is often included in the ETF’s name. It is also specified in the key information document along with the name of its provider. However, this information alone is not enough to fully understand the index: you need to examine its composition in more detail directly on the provider’s website. For a sector index, for example, check whether a particular company or geographic region is overrepresented and ask yourself why. Conversely, for a geographic index, verify its actual scope, and if one industry is more heavily weighted than another, investigate the reason.
Best Practices Before an Investment
Don’t be fooled by how easy it seems to invest in ETFs. Even within a single market, there can be a wide variety of indices. Some ETFs are complex products. Their names, which can sometimes be unclear, may lead to poor investment decisions.
- Before investing, it’s important to understand what you’re buying by learning as much as possible about the ETF’s benchmark index.
- Investing in ETFs should align with your savings goals, the risk level you’re willing to take, and your investment horizon.
- To learn more, carefully read the ETF’s Key Information Document (KID) and prospectus. There you will find details on the fund’s objectives and management policy, its risk-return profile, fees, and more.
- Be fully aware of the risks associated with this type of investment: a decline in the index, tracking error, lack of liquidity in specific ETFs, etc.
- Verify that the ETF is authorized by the AMF or another competent national authority within the European Union, as is the management company offering it.
Spreading Your Diversification Over Time
To take full advantage of a long-term investment time horizon (such as retirement), you should start investing regularly as early as possible. Time is the most valuable ally in long-term savings. “Small streams make big rivers”: the accumulation of regular contributions eventually builds up a significant amount of capital.
The earlier you start, the larger the portion of your portfolio that can be invested in stocks. In fact, when we look at what has happened in the financial markets over the past 50 years or more, we see that the longer stocks were held, the more investments turned out to be profitable. As a result, with 15 or 20 years ahead of you, the risk of loss from a diversified equity investment is low.
Time also allows you to benefit from the compounding effect, which multiplies the amount invested. This is what’s known as the “snowball effect.”
Over several years, gains generate further gains, and in the end (15, 20, or 30 years), a difference in returns translates into savings that have doubled or tripled.
Setting up a long-term savings plan fully justifies seeking professional advice. Assessing one’s personal situation, identifying various long- and very long-term goals, and evaluating one’s investor profile are, in fact, the essential steps in proper financial planning.
The need for diversification applies to anyone who wishes to invest a portion of their savings to achieve a long-term savings goal. Diversification is for those who are willing to take calculated risks with the goal of obtaining, over time, the best possible return on their savings.
INVESTOR CHECK
Set asset allocation first, use broad low-cost exposure where appropriate and check for hidden overlap.
RISK NOTE
This guide is financial education, not a promise of returns or personalized investment advice. Products, tax treatment and investor protections vary by jurisdiction.
[/SPOILER]
- Investor.gov - Beginner's guide to asset allocation - United States - asset allocation and diversification.
- Investor.gov - Index funds - United States - index-fund basics.
- Investor.gov - Mutual funds and ETFs - United States - fund structure.
