If there's one consistent piece of advice that Wall Street analysts and gurus try to impress on retail investors, it's to diversify their holdings and not place all their eggs in one basket. This is advice that fund manager and investor extraordinaire Sir John Templeton included among his more than one dozen rules of investing. According to Templeton: "Diversify. In stocks and bonds, as in much else, there is safety in numbers." 

Why diversification is important for investors

Diversifying your investment holdings, even within the stock market, comes with one major advantage: It reduces investment risk. By spreading your money across a number of holdings, you can reduce the possibility of bad news from one company taking a big bite out of your nest egg.

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Along those same lines, diversification also allows investors to put their money to work in industries or sectors that might otherwise be considered risky or above their typical risk tolerance. As an example, biotech tends to be exceptionally hit and miss, with many drug trials failing to reach their primary endpoints, leading to losses for businesses and investors. Of course, drugs that are successful in clinical studies can create a windfall of profits for investors. Including safer investments and dividend stocks right alongside biotech stocks is one example of how diversification can be used to your advantage.

Perhaps the most popular diversification tool is the exchange-traded fund, or ETF. An ETF acts like a normal, tradable security on a major exchange, but comes with a few differences. Rather than investing in a single company, an ETF is comprised of a basket of stocks. Sometimes, these baskets can exceed 100, or even 1,000, stocks that are tracked.

Investors can purchase ETFs that track indexes, mirror the performance of specific industries or sectors, focus on growth, value, or dividend stocks, or seek out companies of a certain size (small, medium, or large cap). There are well over 1,000 ETFs for investors to choose from, assuring there's something for every investor who wants to buy an ETF.

However, not all ETFs are created equal, and not all ETFs offer the diversification you'd expect.

Don't buy this ETF is you desire diversification

Case in point: the Invesco QQQ Trust (NASDAQ:QQQ).

The Invesco QQQ Trust is an ETF that seeks to replicate the performance of the Nasdaq 100 Index as closely as possible. The Nasdaq 100 Index includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq that have an average trading volume of more than 200,000 shares daily. 

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Right off the bat you might notice a bit of a problem with this index. Since financial companies are excluded, the Invesco QQQ Trust tends to be highly concentrated in just a few industries. According to its weighting as of June 18, 2018, 61.45% of the ETF's assets were tied up in information technology companies, with another 22.89% listed in consumer discretionary. That's more than 84% of investable funds tied up in tech and retail! The remainder is invested in healthcare (8.96%), consumer staples (3.89%), industrials (2.04%), and telecommunication services (0.76%). That's not diversified. 

But it gets worse. Not only are investors in the Invesco QQQ Trust placing their faith primarily in tech and retail, they're also, whether they realize it or not, placing a good portion of their money on just five companies. Here are the respective weightings within the Invesco QQQ Trust of its largest holdings:

  • Apple: 11.30%
  • Amazon.com: 10.19%
  • Microsoft: 9.44%
  • Facebook: 5.79%
  • Alphabet Class A: 4.99%
  • Alphabet Class C: 4.31%

In terms of market cap (but not in the order listed above), these are the six largest publicly traded companies in the United States. Though it makes sense that they would therefore bear more weighting in the Invesco QQQ Trust, having six securities controlling 46% of invested funds is highly concentrated. Even though these are all companies that have handily outperformed in recent years, investors in the Invesco QQQ Trust would find little protection if they were to head lower.

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Consider buying this, not that

If you're looking to diversify your holdings, the Invesco QQQ Trust isn't the way to do it. Instead, I'd suggest you consider the Vanguard S&P 500 ETF (NYSEMKT:VOO), which invests in the roughly 500 companies that comprise the S&P 500.

To begin with, the Vanguard S&P 500 ETF allows you to buy into an ETF that tracks all industries and sectors representative of the American economy, including financials. There also are 500, market-cap weighted stocks in the Vanguard S&P 500 ETF as opposed to just 100 with the Invesco QQQ Trust. With a very low expense ratio of 0.04%, the Vanguard S&P 500 ETF also won't drain your nest egg with fees.

Long story short, make sure you dig below the surface when analyzing ETFs to add to your portfolio because broad-based ETFs may not be as broad-based as you think.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, and Facebook. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Nasdaq. The Motley Fool has a disclosure policy.