Building a Diversified, Low-Cost, High-Performance ETF Portfolio

In this article you will learn how to build a diversified portfolio of multiple asset classes without having to pay a manager

The stock indexes including the S&P 500 and the Dow Jones Industrial Average have been rising in 2009 but does this mean investors should be all in stock? According to the most recent Survey of Consumer Finances that is what almost all investors have done, however, a few exceptions to that trend.

The top 10% wealthiest Americans have continued to own stock but have also increased their holdings in bonds and income investments. The other 90% have moved out of bonds so completely it no longer registers on the survey. Is one population better off for the choices they have made to diversify or concentrate?

Video: Part One of Building a Diversified Portfolio

What adds more interest to this phenomenon is that over the recent survey period the top 10% wealthiest investors have seen an increase of 100% to their portfolios prior to the most recent crash.

The gains for the other 90% were barely a third of that. This is not a coincidence. Despite the marketing hype and the excitement around the earnings-game there is a reason to be invested in more than just stocks.

Asset allocation and portfolio management are difficult subjects for many investors. This is due in equal parts to the fact that there is a lack of consensus among professionals as to the best way to approach these problems and the issues can be complicated.

These complications can be both cognitive (asset allocation requires a learning process) and emotional (greed often conspires against rational investing). However, there are ways to both simplify the issues and to make it achievable for even very small investors to begin understanding and applying the key concepts behind portfolio management.

In this article series I will introduce the basic concepts of asset allocation through a three step process. You will learn these basic principles.

1. Determining allocation percentages

2. Investing in individual securities (stocks, bonds, futures, etc.) or funds (mutual funds or ETFs)

3. Making adjustments and rebalancing a portfolio

Lets start with determining allocation percentages. Most investment professionals will agree that a blend of asset classes within your portfolio is a good thing but how large those allocations are is a much more cloudy issue. There are basically two factors that you have to consider when deciding on your own allocation strategy.

How much of a bear market burden can you handle

What kind of future returns do you want

These two factors are difficult to reconcile. Higher return assets like stocks are often accompanied by very large and unexpected corrections to the downside leading to a large bear market burden. While investment grade and government bonds have a great deal of capital protection they offer low long term returns.

Here is a good example of how two hypothetical allocations acted during different market conditions.

1. An 80/20% mix of stocks to bonds lost -34% in the bear market of 2000-20002 and lost -54% in the bear market of 2008-2009 (so far)

2. A 20/80% mix of stocks to bonds gained 7% in the bear market of 2000-2002 and gained 14% in the bear market of 2008-2009 (so far)

When looked at during these periods the bear market burden seems to bias investors towards a more conservative bond portfolio. However, over longer periods of time that include bull markets, the higher risk portfolio will outperform the lower risk portfolio including inflation by a ratio of 2:1. Finding the right mix for you is the real challenge within asset allocation.

In the video above, I look at how to start solving this problem so that you can refine your allocation yourself. You will learn thatn there are more than two asset classes to choose from, and the more uncorrelated asset classes you include the better your diversification will be. You will also learn why considering your age and retirement horizon will give you some insight into how heavily you invest in riskier assets like equities. I will start this video series by creating a fairly general asset allocation strategy that we can refine as we progress.

Part 2: Investing across asset classes is as important as diversifying within an asset class

Asset allocation does not have to be complicated. Current market products and cost structures make self-management and asset class diversification more achievable than ever before. In part two of this article I will walk through the decision-process between utilizing individual securities to achieve asset class diversification or ETFs and indexed mutual funds.

You will find that while both options are perfectly reasonable, small investors often lean towards ETFs and funds, and in the video I will explain why.

Video: Part Two of Building a Diversified Portfolio

Diversification is a multi-layered issue. There is horizontal diversification across asset classes and another layer of vertical diversification within each asset class. For example, investing in just a single stock will not optimize the benefits of diversification in the same way investing in 12-40 stocks will. Within each asset class you will have to spread your risk across more than one security and this can be difficult for small investors.

Doing this one stock at a time has one major disadvantage costs. Buying 12-40 individual stocks is certainly possible but commission costs may become prohibitive. For small traders this issue is exacerbated because commissions, which are usually fixed, are a larger percentage of the total investment.

Alternatively, a low cost ETF or indexed mutual fund can provide exposure to many stocks within a single investment and only one commission needs to be paid. In fact, it is possible for an individual investor to use indexed mutual funds to execute a portfolio strategy like we have described and potentially pay no commissions.

The other issue that investors will need to deal with is access. For example, in the portfolio I have constructing within this article series I included commodities as one of the asset classes to increase its diversification, however, when investors think about commodities they think about the futures market. Investing in futures requires a futures margin account, which comes with its own costs and margin requirements that may be prohibitive to small and mid-size investors.

Fortunately investing in commodities, bonds, stocks and real estate can all be done through ETFs or indexed mutual funds. This reduces trading costs, increases sizing flexibility and makes it possible for individual investors to access several asset classes within a single account.

ETFs and indexed mutual funds always come with some costs but these are usually much more reasonable when compared to the convenience and benefits. They are also usually much less expensive that traditional managed funds. In the game of investing, controlling costs is a major priority.

Part 3: Learn how and when to rebalance a diversified portfolio.

With modern financial products even small investors can diversify across several asset classes. However, once achieved do these allocations need to be adjusted? If adjustments are needed how and when is that done? This part of the article will answer those questions.

Video: Part Three of Building a Diversified Portfolio

Some of the most important things to remember from this series of articles is that successful portfolio management relies on simplified processes and low costs. In the last section that meant that most individual investors should have a bias towards funds and ETFs. In this article the same principle applies to keeping allocation adjustments to a minimum.

Adjusting allocations within your portfolio carelessly is a great way to increase trading costs and may lead to over trading. However, some adjustments are usually necessary once asset values have drifted away from the percentage allocations you originally setup.

There are two general ways to approach adjustments. Some traders will reallocate or rebalance their portfolios tactically while others will adjust more passively.

Tactical Reallocation:

Imagine that you have spread your investments evenly across 5 asset classes including stocks and bonds. Assume that a year from now stocks have performed very well and have risen from 20% of your portfolio to 30% while bonds have dropped from 20% to 10%.

A tactical manager may decide that stocks are likely to continue doing well and that even more money should be reallocated to that class. At the same time a tactical manager may decide to reduce their exposure to commodities that that they have decided will become more risky in the near term.

The new asset allocation structure for a tactical manager is based on forecasts and analysis and may continue to change in the future. Often this kind of management is often called market timing.

Passive Reallocation:

As a passive manager you are more interested in trying to maintain your desired exposure levels across asset classes than forecasting the future. That means that in the example above you may wish to increase your exposure to bonds while reducing the stocks component to bring the original allocation back to desired levels.

Passive managers typically reallocate based on a calendar date (every 6 or 12 months for example) or based on investing objectives. A passive manager may reallocate assets if their lifestyle or objectives change or on a regularly scheduled plan. This keeps things very simple and prevents over trading.

The principles presented here are not complicated but they can be very powerful over the long term. They can help reduce major portfolio shocks while producing significant returns. From here we will begin working through the practical issues of asset class diversification. You will learn more about how to decide what percentages are appropriate for you, how to find individual investment ideas and what brokerage services are needed.

Part 4: Diversification is easier than you thought and you can do it without a manager

In the first and second sections of this article I glossed over the percentage allocation problem with a fairly generic allocation of 20% per asset class across 5 classes. If you take a closer look, you will see that the portfolio was evenly allocated across risk categories as well. There are a lot of complicated ways to allocate assets and for determining how they should change over time, but it really doesnt have to be more complicated than that.

Video: Part Four of Building a Diversified Portfolio

For example, a classic rule of thumb is to allocate the same percentage of your assets as your age to conservative investments like bonds and the remainder to riskier assets like stocks. If you are 35 now that means you should have 35% in bonds and the rest in stocks. Similarly, once you reach age 65, you should have 65% in bonds and the rest in stocks.

However, if you think about this strategy for a minute you will find that over those years you were, on average, allocating 50% to bonds and 50% to stocks. You could accomplish the same objective without a lot of age-based rebalancing by just allocating this way in the first place and then remaining consistently balanced.

The point behind this example is to show that you dont need to get too fancy with your allocation strategy. Find a balance that suits your risk tolerance and stick with it. If your life style changes and your risk tolerance changes with it then make changes. Over thinking the portfolio percentages problem doesnt ultimately do very much for you.

Finding Investments

In this series we emphasized the benefits of ETFs or indexed mutual funds as a very low cost alternative to individual securities, futures and bonds. However, this still leaves a pretty large pool of choices available.

Broker Issues

This is where many traders make mistakes. Some brokers specialize in attracting the active investor and may penalize low activity accounts with fees or low/no interest payments on cash reserve balances. Alternatively, many brokers specializing in longer term accounts may charge large commissions up front.

Take some time when evaluating your broker or potential brokers by asking them to quote commissions, fees and interest on cash balances based on your portfolio strategy rather than based on their published rates. Published broker rates can be very biased and difficult to understand within the context of your portfolio needs.

There is an investing adage that says; your life should be interesting and your investing should be boring. To a certain extent we feel that is true although we think boring should be replaced with simple. Modern financial products like ETFs and online brokers have put the tools of the professional in the hands of the consumer investor. Get a little education and you can be on your way to becoming a successful portfolio manager.

Part 5: How to use strategic diversification to increase your profitability

In this article we have discussed a simple but effective way to build a portfolio of diversified assets across different classes and instruments. If you want to stop there that is fine and you could easily become a very effective investment manager.

Or you can move on from here and start learning how to implement investing strategies designed to continue reducing account volatility and increase profits. This article will introduce you to the topic of strategic diversification and give you a starting place to begin learning about options strategies.

Video: Part Five of Building a Diversified Portfolio

Diversification is the only free lunch in the market because it comes with benefits and no disadvantages. However, many traders have no idea what diversification actually is or how to maximize its benefits.

As we have discussed in this series, there is more to a diversified portfolio than just a large pool of stocks, and I think it is easiest to think about diversification in three layers;

1. Horizontal Diversification spreads investment capital across several asset classes. An investor using horizontal diversification may have market exposure to stocks, bonds, currencies, treasuries or other asset classes at the same time. Within each of those asset classes, a prudent investor could use vertical diversification to maximize their benefits.

2. Vertical Diversification is what you are doing when you invest money allocated to the stocks asset class across several industry groups or within an indexed ETFs like SPY, IWM or DIA. This helps limit your exposure to unknown disruptions within individual stocks.

3. Strategic Diversification is a way to think about using more than just long positions to invest in the market. For example, option investors will sell calls against a long position to reduce account volatility. Stock traders using this strategy call it a covered call.

Over the long term, reducing volatility in this way can be shown to increase returns and reduce risk, but this is just an example starting place when beginning to diversify across strategies.

Strategic diversification is the answer to whats next? when thinking about building a diversified portfolio. Many traders start with covered calls and similar strategies and begin building on that knowledge to create a management plan that improves their ability to achieve better returns with less risk than they could have otherwise. Learning Markets exists to help you understand the strategic options available and to help you implement them.