Diversification is a risk management technique that strives to reduce Un-systemic Risk by investing in uncorrelated assets. In essence, the term means, “Don’t put all your eggs in one basket”.
Asset Allocation employs diversification to allocate a portfolio amongst the main asset classes, stock, bonds, and cash. A well-diversified portfolio takes this a step further and allocates each asset class amongst its categories. For instance, within the stocks asset class, an investor would diversify his assets amongst large-cap/small-cap and growth/value. Typical asset classes and categories include:
Capitalization: Small-cap, Mid-cap, Large-cap
Growth/Value: Growth, Value, Blend
International Equities: Emerging Markets or Development Markets
Duration: Short-term, Intermediate-term, Long-term
Quality: Low, Mid, High/Investment Grade
Corporate or Government (Treasuries or Munis)
Exchange-Traded Funds (ETFs) are an excellent way to diversify portfolios. As shown by the following diagram, iShares ETFs invest in a wide universe of underlying securities (iShares is one of the largest ETF players in the ETF space.). Each tiny spec in the diagram represents a holding of an iShares ETF. What might look like modern art is actually 100,000 holdings of iShares' 300 ETFs!
While ETFs are excellent diversification tools, investors should be cautious to avoid investing in similar ETFs with similar holdings. As shown by the following example, eight holdings are shared amongst 25 or more iShares ETFs. For example, Microsoft (MSFT) is a common holding of 27 iShares ETFs (e.g. IGM, JKD, KLD, etc.)
As another example of common holdings amongst many ETFs, take a look at the following diagram. The aqua circles represent iShares ETFs and the orange circles represent Microsoft stock and bonds. Not only is MSFT stock a common holding of27 iShares ETFs, but MSFT bonds are also significant holdings of many other iShares ETFs.