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Investing with Exchange-Traded Funds Made Easy: Higher Returns with Lower Costs - Do It Yourself Strategies Without Paying Fund Managers

Understanding Exchange-Traded Funds

Getting Started in Exchange Traded Funds (ETFs)

Previous:
Commodities ETFs

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How to Build a Portfolio with ETFs and Other Types of Investments

How to Build a Balanced Investment Portfolio with ETFs

Your investment portfolio is a term that refers to the complete array of your investments. Most investors aim to build a balanced portfolio, which means a portfolio that contains just the right amount of each major asset class, as determined by the investor’s ideal asset allocation. Whereas in the past most individual investors bought various mutual funds to build a balanced portfolio, these days it’s possible to build an entire portfolio exclusively with ETFs. Portfolios built using ETFs provide all the benefits of ETF investing, such as lower expense ratios and few capital gains tax bills.

How to Assess Your Risk Tolerance

To determine the asset allocation that suits you best, you first need to assess your risk tolerance—the amount of risk that you personally feel comfortable taking on in your investments.

Investors with a high risk tolerance: Also known as aggressive investors, these investors must be able to tolerate the short-term volatility of risky investments in exchange for the superior long-term returns that those investments tend to provide.
Investors with a medium risk tolerance: Also known as moderate investors, these investors should buy a somewhat even mix of investments that will likely grow in value, such as stocks, and investments that provide steady income with lower risk, such as bonds.
Investors with a low risk tolerance: Also known as conservative investors, these investors should usually buy lower-risk investments, such as bonds, that provide a steady stream of income without the prospect of high returns over time.

To determine your ideal risk tolerance, consider your time horizon, financial situation, as well as your personal response to risk.

Time Horizon

Your time horizon is the amount of time you have before you’ll need the money you invest. For instance, a 25-year-old who plans not to sell his or her investments until age 65 has a 40-year time horizon.

Time horizon isn’t just a function of your age or when you expect to retire. For instance, a young investor hoping to grow his or her investment portfolio for the purpose of buying a home in three years has a short time horizon.

How Time Horizon Impacts Risk Tolerance

Time horizon has a direct relationship to risk tolerance:

The longer your time horizon, the greater your risk tolerance: Short-term dips in the markets won’t affect you, since you won’t need the money in the short term.
The shorter your time horizon, the lower your risk tolerance: Your wealth will be harmed if a short-term dip in the market cuts into your investment just before you need to use the money to pay for retirement, a house, or any other important expense.

Your Personal Financial Situation

A major factor in your risk tolerance is whether you depend on the income that your investments provide. For instance:

A person who is retired and has no other source of income other than that generated by investments is dependent on investment income.
A person who has a secure job that pays the bills and provides extra money for savings is not dependent on investment income.

Investors who depend on investment income have a low risk tolerance, since they can’t afford any interruption to that income. Investors not dependent on investment income have a higher risk tolerance, since they can accept short-term volatility in exchange for long-term returns.

Your Personal Response to Risk

In addition to the risk that you can accept financially, risk tolerance also includes how you feel, personally, about taking risks and losing money. Always consider adjusting your risk tolerance based on your personal response to risk when determining your ideal asset allocation.

If you avoid risk in everyday life or worry easily: It’s likely best for you to avoid high-risk investments, such as small-cap stocks. In exchange for potentially lower returns, you’ll have less stress and lower volatility.
If you enjoy risk and don’t worry easily: You’d probably feel comfortable buying risky investments—assuming that your time horizon and life situation support that high-risk approach.

Sample Asset Allocations

Asset allocation is the process of determining how much of each type of asset you should own, based on your risk tolerance. The following table provides suggested asset allocations for investors with high, moderate, and low risk tolerances. The last column in the table, “Cash,” refers to cash equivalents, which are investments such as CDs and money market funds (a type of mutual fund) that provide a steady stream of income with close to no risk.

Risk Tolerance	Stocks	Bonds	Cash
High	80%	20%	0%
Medium	30%	40%	30%
Low	10%	20%	70%

You can use ETFs to build a portfolio with these asset allocations. For example, if you have $10,000 to invest and have a medium risk tolerance, you might comfortably invest $3,000 in stock ETFs, $4,000 in bond ETFs, and $3,000 in cash equivalents.

ETFs and Diversification

Your next step in building an investment portfolio using ETFs is to decide how to diversify your portfolio within stocks, bonds, and cash equivalents. The diversification choices you make should depend on your risk tolerance and on the expense ratio of the ETF.

Diversification and Expense Ratios

When choosing between two ETFs that track similar indexes, it almost always makes the most sense to choose the one that has the lowest expense ratio. For instance, if you’re choosing between two REIT ETFs, the ETF with lowest expense ratio is probably the better choice, since most of the REIT ETFs currently available have provided similar returns.