NEW YORK (CNN/Money) - I am using Diamonds, Spydrs and iShares as the core of my equity portfolio. What would be a good reference for market diversification through sector analysis?
First, just so nobody thinks we're speaking in some sort of secret code, let me briefly explain what Diamonds, Spydrs and iShares are. Essentially, all of these are types of index funds -- that is, funds whose portfolios contain the securities that make up a specific index or benchmark. For more on index funds and how they operate, click here.
Diamonds, for example, track the performance of the 30 stocks in the Dow Jones Industrial Average, while Spydrs monitor either the Standard & Poor's 500 index overall or a specific industry within the S&P 500 (utilities, technology, financials, etc.). iShares, on the other hand, come in a huge
number of varieties, allowing you to track everything from the U.S. stock market overall (the Dow Jones U.S. Total Stock Market Index) to specific slices of the U.S. market (small-, mid-size or large-company stocks, value or growth stocks, 11 different industries) to a variety of international indexes
(European, Asian, South American stocks, not to mention specific countries.) Unlike regular mutual index funds, however, iShares, Diamonds and Spydrs trade like stocks. That's why you'll also see them referred to as ETFs, or exchange-traded shares.
Buying sector by sector
One reason to buy these indexes is that they allow you to track a specific slice of the market without having to pick specific stocks. So, for example, if you want to invest in the financial sector but don't want to analyze zillions of bank, insurance company and other financial stocks to figure out which are the best buys, you can buy essentially the entire financial sector by buying, say, the iShares or Spydr financials shares. What you'll get is a portfolio of financial stocks weighted by their market capitalization or market value. In other words, the largest financial companies, such as Citigroup and Bank of America, will represent a much larger portion of the portfolio's assets than small regional banks and financial institutions.
The second reason many investors also invest in ETFs is that these indexes allow you to customize your portfolio to virtually any specs you like. Think tech is poised for a big comeback? You can jack up the percentage of your portfolio allocated to tech iShares or Spydrs. Think energy stocks will shine? Then you can load up on energy ETFs. In other words, you can shift the allocations of various industries or styles (growth or value, large or small stocks) depending on your outlook for the market.
I like the first reason for buying ETFs -- that is, tracking an index -- but I don't like the second reason. Why? Because I don't believe any investors have a real clue as to which sector or style will outperform in the future. Thus, I believe it's risky to tilt your portfolio toward a specific industry, say, in hopes that industry will take off in the future. The risk, of course, is that if the industry doesn't take off -- or fizzles after you've dumped a lot of your money into it -- then you can see your portfolio's value plummet.
Stay broadly diversified, though
My advice: if you want to buy ETFs, stick to ones that track broadly diversified indexes, like the S&P 500 or the total U.S. stock market. But if you want to overweight certain styles or indexes because you believe you know which sectors of the market are poised to surge, then at least don't overdo it. That way, if you're wrong, you won't get creamed.
As a reference point for diversification, I suggest you check out Morningstar's site. Just go to the Instant X-ray tool, insert the symbol for the Vanguard Total Stock Index fund (VTSMX) and click Show Instant X-Ray. Immediately, you'll see how the U.S. stock market overall is diversified among large-, mid- and small-cap stocks, by growth and value and by 10 specific industries. I'm not saying you've got to duplicate the market's weightings down to the second decimal point. But if you stray very far from those weightings and your bet turns out to be wrong, then your portfolio probably won't do as well as the market during upswings and will likely fall more than the market during downturns.