When it comes to building a resilient investment portfolio, diversification is often described as the only “free lunch” in investing. By spreading investments across a range of assets, investors reduce the risk that any single underperformer will significantly drag down their overall returns. But how exactly should investors think about diversification when weighing the merits of ETFs versus direct shares?
This article explores what each investment type offers, why investors might choose to combine them, and the benefits and trade-offs of doing so — all while keeping decisions anchored in personal goals, risk tolerance, and long-term thinking.
What are ETFs and how do they support diversification?
Exchange-traded funds (ETFs ) are investment vehicles that bundle together a broad set of assets — such as shares, bonds, or commodities — and trade on an exchange like a single stock. Most ETFs are passively managed and track an index. For example, an ASX 200 ETF aims to reflect the performance of the 200 largest listed companies in Australia.
Because each ETF contains many individual holdings, even a single ETF can provide built-in diversification . For instance:
- A global ETF might spread holdings across hundreds of companies in North America, Europe, and Asia.
- A thematic ETF might focus on emerging sectors like clean energy or AI, capturing a diversified set of companies within that theme.
- A bond ETF might include government and corporate bonds of varying maturities.
This makes ETFs a potentially simple and cost-effective way for investors to access broad market exposure, often with lower fees than actively managed funds.
What does it mean to invest in direct shares?
Direct shares refer to buying and owning individual stocks in specific companies . Rather than holding a basket of businesses like you would with an ETF, investors in direct shares choose particular companies to include in their portfolio.
This approach offers:
- Greater control: Investors can pick companies that align with their values, interests, or convictions.
- Concentration: Some prefer to concentrate their portfolio in areas they believe will outperform.
- Tax strategies: Investors may choose to sell underperforming shares to realise capital losses for tax purposes (known as tax-loss harvesting).
- Learning opportunities: Holding direct shares can deepen an investor’s understanding of businesses, industries, and market dynamics.
However, investing in direct shares usually involves more research and monitoring, and can lead to a less diversified portfolio if not managed carefully.
Why might someone want to combine both?
Many investors choose to blend ETFs and direct shares in their portfolio. This can serve a range of purposes:
- Broad exposure with room for conviction: An investor might use ETFs to gain wide exposure to the global economy, while selecting a few direct shares they believe in personally — whether for growth potential, values alignment, or curiosity.
- Tactical investing: An ETF might lack exposure to certain sectors. For example, some Australian-focused ETFs may underweight global tech companies. To fill this gap, an investor might add direct shares like Microsoft or Nvidia.
- Legacy holdings: Investors who’ve inherited or accumulated direct shares over time may continue to hold them alongside ETFs.
- Learning by doing: New investors may use ETFs as a low-effort foundation and add direct shares gradually to build skills and confidence.
Example:
Alex is a long-term investor who holds a diversified global ETF covering developed and emerging markets. They also own a small number of individual shares companies they admire — such as, for example, Tesla and Fortescue Metals — to stay engaged with industries they’re passionate about.
What are the potential benefits of combining them?
Bringing ETFs and direct shares together can offer several potential advantages:
1. Blending passive and active approaches
ETFs typically represent a passive strategy , tracking the market without trying to beat it. Adding direct shares introduces a light active layer , enabling investors to pursue personal convictions without overhauling their whole portfolio.
2. Filling diversification gaps
No single ETF can cover everything. For example, an ASX-focused ETF may be heavily weighted toward banks and mining companies, while underexposed to healthcare or technology. Adding direct shares from underrepresented sectors may complement this.
3. Greater engagement
Investors often feel more emotionally connected to companies they’ve chosen themselves. This can increase interest in markets, prompt deeper research, and promote a long-term mindset — all useful traits for values-based investors.
4. Customisation
A blended portfolio allows for greater personalisation . Investors can tailor their holdings to match ethical preferences, tax considerations, or goals like dividend income or capital growth.
What are the trade-offs or risks?
Combining ETFs and direct shares also introduces challenges that are worth considering:
1. Over-concentration
Without careful planning, investors might unintentionally double up on exposures. For instance, someone might hold an ETF tracking the ASX 200 and also hold direct shares in BHP and CBA — both of which are already heavily weighted in the ETF.
2. Portfolio complexity
More moving parts mean more to track. Investors need to manage multiple holdings, understand their roles in the portfolio, and stay organised around rebalancing, dividends, and tax records.
3. Higher costs
While ETFs tend to be low-cost, brokerage fees for buying and selling direct shares can add up. And if an investor is frequently switching between holdings, trading costs — and potential tax implications — increase.
4. Behavioural risks
Having direct control over individual shares can tempt investors into emotional decision-making. This might include chasing trends, reacting to short-term news, or overestimating their ability to pick winners — behaviours that can reduce long-term returns.
What frameworks can investors use to combine them?
There’s no one-size-fits-all formula, but a few common frameworks can help investors think through how to blend ETFs and direct shares:
1. Core-satellite approach
- Core: Most of the portfolio (e.g. 70–90%) is allocated to diversified ETFs.
- Satellite: A smaller portion is invested in direct shares for added personalisation or tactical exposure.
- This approach may deliver broad coverage while allowing for some strategic choices.
2. Fixed ratio
- Some investors decide on a set percentage — such as 80% ETFs and 20% direct shares — and stick with it over time.
- This can support discipline and reduce the likelihood of the portfolio drifting too far into concentrated territory.
3. Start with ETFs, add shares slowly
- Beginners might begin with ETFs and layer in direct shares gradually as they learn and grow in confidence.
- This allows for hands-on experience without sacrificing diversification early on.
4. Check for overlap
- Regularly reviewing portfolio holdings helps avoid duplication.
- Many ETF providers publish full holdings lists, making it easier to spot if a direct share is already included and heavily weighted.
Example:
Mia has 80% of her portfolio in global and Australian ETFs. She also owns direct shares in Apple and Xero. By checking her ETF holdings, she notices Apple already represents 3% of her global ETF — helping her decide whether to maintain or adjust her exposure.
Final thoughts
Combining ETFs and direct shares can be a powerful way to build a more diversified and personally aligned investment portfolio. ETFs offer broad, low-cost exposure and simplicity. Direct shares offer control, learning opportunities, and emotional engagement.
The key is not choosing one over the other, but rather using each intentionally. Whether someone prefers to stick with passive investing, express their convictions through a few direct holdings, or build a personalised blend of both, it all comes down to aligning with their own goals, risk tolerance, and long-term mindset.
As always, investing isn’t about chasing perfection — it’s about finding an approach that works for you and staying the course.
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