Exchange-traded funds (ETFs) are an excellent way to diversify your portfolio, but they can also concentrate it if you don't ensure your assets are balanced. When structuring your investment portfolio with ETFs, it's essential to define your goals and risk tolerance, determine the correct asset mix, and then select the right ETFs.
ETFs are similar to mutual funds but are traded on an exchange like stocks, providing higher liquidity and transparency. They are also relatively inexpensive, making them a popular choice for investors.
1. Figure out your risk tolerance: Consider your time horizon, risk capacity, and risk tolerance. If you're investing for the long term, you may be able to take on more risk.
2. Determine your investment mix: Decide on the allocation between stocks and bonds, as well as the mix between US and foreign stocks. This will depend on your risk tolerance and investment goals.
3. Choose specific ETFs: Look for ETFs with low expense ratios and a broad market index focus. Diversify your portfolio by investing in a range of asset classes, holdings, and geographic regions.
4. Make your trades: Place trades to buy the selected ETFs, ensuring you have the ticker symbols and allocation percentages ready.
5. Monitor and adjust: Periodically review your ETF portfolio to ensure it meets your needs and goals, and make adjustments as necessary.
Remember, it's important to seek advice from a financial advisor if you're unsure about the process or your specific circumstances.
Characteristics | Values |
---|---|
Risk level | Appropriate for your situation |
Investment mix | Targeted mix of stocks and bonds |
ETFs | Specific ETFs for each bucket of the investment mix |
Monitoring | Occasional adjustments |
Trading | Buy ETF portfolio |
Portfolio check | At least once a year |
Rebalancing | Once a quarter or annually |
Diversification | Multiple asset classes, multiple holdings, multiple geographic regions |
Liquidity | Higher |
Transparency | Higher |
Control | Lower |
Costs | Lower |
What You'll Learn
Determining the right asset allocation
- Risk Tolerance and Investment Objectives: The first step is to assess your risk tolerance and define your investment objectives. Consider your financial goals, time horizon, distribution needs, tax situation, and personal circumstances. Are you investing for retirement, saving for a child's education, or something else? The time horizon plays a crucial role, as a longer investment period generally allows for taking on more risk.
- Asset Allocation Models: Once you understand your risk tolerance and objectives, you can explore asset allocation models that align with your goals. This involves determining the mix of stocks, bonds, and other asset classes in your portfolio. Younger investors with longer time horizons are typically advised to allocate more to stocks, as they have a higher risk-return potential over the long term.
- Diversification: Diversification is a key benefit of ETFs, and it's important to ensure your portfolio is well-diversified across multiple asset classes, geographic regions, and investment types. This can be achieved by investing in a mix of ETFs covering different sectors, industries, and markets.
- Risk and Return Trade-off: When determining your asset allocation, it's essential to understand the trade-off between risk and return. While a higher allocation to stocks may offer higher potential returns, it also comes with greater volatility and risk. Bonds, on the other hand, tend to be less risky but may provide lower returns over time.
- Target-Date Funds: If you're unsure about your exact asset allocation, consider using target-date funds as a guide. These funds adjust their asset allocation based on a predetermined time horizon, gradually shifting towards less risky investments as the target date approaches.
- Seek Professional Advice: Consult a financial advisor if you need help determining your asset allocation. They can provide personalized guidance based on your specific circumstances, risk tolerance, and financial goals.
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Choosing specific ETFs
When choosing specific ETFs, you will generally want to be broadly diversified among many different investment types. For example, in the US stock portion of your portfolio, you might diversify by owning stocks from companies in a wide variety of industries and by owning some smaller companies in addition to large companies.
- Targeted investment universe: ETFs could fall into the same broad category but target very different parts of those investment universes. Checking each ETF's objective and benchmark can help you choose an appropriate ETF for each role in your portfolio.
- Active vs. passive: An active ETF is generally run by one or more professional managers who evaluate investments and decide what to hold in the ETF. A passive ETF (aka index ETF) tracks the performance of an index, generally by holding the same investments the index tracks.
- Expense ratio: This is the cost of investing in a given ETF. Many investors choose ETFs for their relatively low-cost structures.
- Issuer: Some investors prefer to invest with an established ETF provider with a strong reputation and a long investing track record.
- Analyst ratings: Many ETFs receive ratings from firms that analyze ETFs. These ratings are intended to measure how well an ETF is managed in terms of its cost, efficiency, and other factors.
- Total bond ETFs: These invest in a combination of short-, intermediate-, and long-term bonds with varying degrees of credit quality and risk.
- Total stock ETFs: These invest in a combination of small, mid-size, and large companies with varying degrees of value and growth.
- International ETFs: These may focus on emerging markets, developed markets, or both.
- Commodity ETFs: Everything from gold to cotton to corn can be tracked with ETFs or their cousins, exchange-traded notes (ETNs).
- Real estate ETFs: These can be further split into US and global.
- Socially conscious ETFs: These invest in companies with strong environmental, social, and governance (ESG) track records.
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Buying your ETF portfolio
Once you have determined your risk tolerance and asset allocation, it's time to buy your ETF portfolio.
If you are an experienced investor, you may already know how to place trades. But if you are new to investing, the process can be nerve-wracking. You will need to have each ETF's ticker symbol handy and translate your targeted percentage allocations into dollar amounts.
You will also need to decide how much money to invest in your portfolio. Even if you start with as little as $100, the magic of compounding can make a difference over the long term.
It is important to remember that investing involves risk and you could lose money. You should ensure you understand the basics of ETFs and the risks involved before investing.
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Monitoring and adjusting
Regular Check-Ins
It is recommended to periodically check in on your ETF portfolio to ensure it is still meeting your needs and goals. While the ideal frequency may vary, a yearly review is generally considered sufficient for most investors. This review can be done at the beginning or end of the calendar year, taking into account any changes in your circumstances while maintaining a long-term perspective.
Performance Evaluation
When evaluating the performance of your ETF portfolio, compare each ETF's performance to that of its benchmark index. Any significant difference, known as a tracking error, may indicate a need to replace that particular fund with one that aligns more closely with its stated style. It is important to assess the performance relative to the benchmark rather than in isolation.
Rebalancing
Over time, your portfolio may drift away from its targeted investment mix. Therefore, it is important to periodically rebalance by placing trades to bring your portfolio back on track. This could involve trimming positions that have grown to become an oversized portion of your portfolio or adjusting your investment mix to reflect changes in your goals or risk tolerance.
Investment Evaluation
It is crucial to evaluate the performance and role of each investment within your portfolio. Each ETF should have a specific purpose. For example, if you have purchased an ETF to track the performance of US large-cap stocks, ensure that it is performing in line with this objective. If an investment is not fulfilling its intended role, you may need to reconsider its place in your portfolio.
Additional Investments
As you save more towards your investment goals, you may need to place additional trades to invest this extra cash and maintain your targeted investment mix. Automating this process, such as through regular monthly contributions, can help streamline your investment journey.
Tax and Legal Considerations
Long-Term Perspective
While short-term market fluctuations may occur, it is important to maintain a long-term perspective and stick to your original allocations. Avoid the temptation to time the market, as research has consistently shown that this is not a winning strategy. Instead, focus on your overall investment strategy and make adjustments as needed based on your goals and risk tolerance.
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Using a robo-advisor
Robo-advisors are a type of automated financial advisor that provides algorithm-driven wealth management services with little to no human intervention. They are a low-cost, online investing platform that employs software algorithms to create and manage investment portfolios for their clients. Robo-advisors are designed to remove the guesswork from investment decisions, using proven strategies tailored to each user's risk tolerance and financial goals.
Robo-advisors are ideal for investors who want a managed portfolio but do not want to pay the high fees of a human financial advisor. They are also a good option for those with smaller amounts of money to invest due to their reasonable fees and low minimum deposit requirements.
- Wealthfront: Best Overall Robo-Advisor. Wealthfront has a low required minimum investment of $500, vast customisation options, fee-free stock investing, and dynamic tax-loss harvesting.
- Betterment: Best for Beginners. Betterment has a low account minimum of $10, a range of portfolio choices, and excellent tax strategy.
- SoFi Automated Investing: Best for Low Costs. SoFi has no annual advisory fee and access to financial advisors with no additional cost.
- M1 Finance: Best for Sophisticated Investors. M1 Finance offers a one-of-a-kind investment portal suitable for strategic investors who want access to customised portfolios.
- Acorns: Best for Those Who Struggle to Save. Acorns has a "round-up" feature that automatically invests your spare change.
- Ellevest: Best for Women Investors. Ellevest offers financial management tailored to women's specific career and life situations, such as lower earnings and longer lifespans.
- ETRADE Core Portfolios: Best for Mobile. ETRADE Core Portfolios provides a solid robo-advisor platform with a user-friendly mobile app.
- Merrill Guided Investing: Best for Education. Merrill Guided Investing offers expansive financial education resources and a solid robo-advisory service.
When choosing a robo-advisor, consider factors such as fees, investment options, account types, advice and usability. Additionally, evaluate whether you prefer a robo-advisor that offers a human touch, such as access to financial advisors, or one that is completely automated.
Robo-advisors provide an attractive option for those seeking a low-cost, automated approach to investing. By using computer algorithms, robo-advisors can construct and manage investment portfolios that align with their clients' goals and preferences.
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Frequently asked questions
ETFs are baskets of individual securities, much like mutual funds but with two key differences. First, ETFs are traded on exchanges like stocks, while mutual fund transactions don't occur until the market closes for the day. Second, expense ratios tend to be lower.
When determining which ETFs are best suited for your portfolio, there are a number of factors to consider. First, look at the top holdings of the ETF. It's also important to compare how similar ETFs have performed and watch out for any notable differences in expense ratios. Another factor to pay attention to is the total amount of assets under management (AUM).
First, determine the right allocation. Then, implement your strategy by analysing the available funds and determining which ones will best meet your allocation targets. Finally, monitor and assess your portfolio at least once a year.
One option is to use a total world stock market ETF and a total bond market ETF to provide a balanced, diversified portfolio. Another approach is to use around 8 ETFs, including large-cap and small-cap US ETFs, international developed-market ETFs, emerging-market ETFs, and bond ETFs.