How to Build a Simple and Effective All-ETF Portfolio
So you’ve decided you want to invest in ETFs due to their many advantages. But now come the questions: Which ETFs should you invest in? How many do you need to invest in to reap the benefits of diversification? How often do I need to buy/sell ETFs? Don’t worry; we’ve got you covered.
How Portfolios Work
An investment portfolio is an individual’s collection of investments. The key to any good portfolio is diversification of the different type of assets that an individual holds. The basis behind diversification contends that a good mix of a variety of asset classes (equities, bonds, real estate, currency, commodity, and multi-asset) will — over the long run — yield a positive return at lower risk than the individual investments themselves.
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How to Determine Portfolio Holdings
When determining the make-up of your portfolio, there are several questions to consider:
- What is your investment horizon? An investment horizon is the amount of time that you expect to be invested. If you’re saving to buy a house in the next couple of years, perhaps your investment horizon is small; but if you’re saving up for retirement 35 years from now, you have a longer investment horizon. To a certain extent, your investment horizon will dictate your risk tolerance.
- What are your goals? Again, why are you investing? Are you saving for a house, college, retirement?
- How much risk are you willing to take on? The amount of risk you’re willing to take on should depend somewhat on your age. The younger you are, the more time you have to make up any losses realized by risky equity holdings. As you age, your risk tolerance is likely to decline, pushing you into less risky assets such as bonds.
Generally, it’s a good idea to invest in a good mix of equity holdings (stocks) and bonds. A good rule of thumb to follow is to invest (110 – your age) in equity holdings and the remaining amount in bonds. For instance, if you are 30 years old, you would invest 80% in stocks (110 – 30 = 80) and the remaining 20% in bonds.
It’s a good idea to diversify within asset classes as well. It would be unwise to hold 80% of your entire investment portfolio in one company or one sector of the economy. A prudent investor will spread out his risk in his 80% equity holdings to include a good mix of growth and value equities as well as large- and small-sized market caps. Also, it’s usually a good idea to invest some holdings in non-US equities to further diversify. As you grow older, your portfolio would slowly shift out of stocks (high risk) and into bonds (low risk), as your investment horizon got smaller.
ETFdb’s Sample Portfolio for a 30-Year Old Investor
Let’s consider the case of a 30-year old person saving for retirement. His investment horizon is approximately 35 years, so we have a good amount of time to take some risks early on. We’ll use the 110 – age rule to determine equity/bond holding ratio.
- 60% U.S. Total Market (Vanguard Total Stock Market ETF: VTI)
- 20% International Equities:
- 20% Bond/Fixed-Income (Vanguard Total Bond Market ETF: BND)
Perhaps you’re thinking: Can I really have an effective portfolio with as few as four ETFs? The answer is a definite ‘yes.’ Most individual investors and mutual fund managers won’t even match the indexes’ returns, so simple low expense portfolios such as this one will, in the long run, tend to outperform portfolios that contain individual stocks or actively-managed mutual funds. A good portfolio doesn’t need to be complex.
Rebalance at Regular Intervals
As time passes and you get older, you will want to regularly re-balance your portfolio (once a year is good) to ensure that you have the proper equity/bond holding ratio. You’ll also want to ensure that your diversification among asset classes of your equity holdings is still in line with your goals, as the rise or decline in value across different classes will dictate. For instance, if your goal is to keep VTI at 60% a year from now, you should buy or sell enough VTI shares after a year to stay on track.