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How to Manage Risks with ETFs

Asking how risky, or how lucrative, ETFs are is like trying to judge a soup knowing nothing about the soup itself, only that it is served in a blue china bowl. The bowl — or the ETF — doesn’t create the risk or reward; what’s inside it does.

Basically, stock and real estate ETFs tend to be more volatile than bond ETFs. Short-term bond ETFs are less volatile than long-term bond ETFs. Small-stock ETFs are more volatile than large-stock ETFs. And international ETFs often see more volatility than U.S. ETFs.

To minimize risk and maximize return, diversify. Include both stocks and bonds and both domestic and international holdings in your portfolio. You also need to diversify the domestic stock part of a portfolio, and that part’s a bit trickier, because not even the experts agree on how to accomplish that.

Two competing diversification methods predominate, and either is fine (as is a mixture of both for those with good-sized portfolios):

  • Divide the portfolio into domestic and foreign, and then into different styles: cap size (large, small, and mid), value, and growth.

  • Divide the portfolio up by industry sector: healthcare, utilities, energy, financials, and so on.

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