You don’t need to meticulously pick and choose hundreds of stocks and securities to make up a portfolio. Instead, investors can use five low-cost exchange traded funds to create a diversified, long-term investment portfolio.
Harry Markowitz, the Nobel Prize-winning father of modern portfolio theory, argues that all investors should choose a similar diversified risky portfolio that consists of a combination of stocks and bonds to provide the greatest return for the least amount of risk, writes Barbara Friedberg for US News.
With ETFs, investors can create a diversified portfolio of risky stocks and conservative bonds. However, it is up to the investor to decide how much risk they are comfortable with, depending on his or her risk aversion and investment horizon. For instance, someone who is closer to retirement should consider shifting more of his or her equity position in to fixed-income assets.
From the Morningstar’s “ETF Nalysts’ Favorites,” Friedberg points out five ETF options, including the Vanguard Total Stock Market ETF (NYSEArca: VTI), Vanguard Small-Cap ETF (NYSEArca: VB), Vanguard FTSE All-World ex-US (NYSEArca: VEU), Vanguard Total Bond Market ETF (NYSEArca: BND) and iShares TIPS Bond ETF (NYSEArca: TIP). [Diversified Growth ETFs for a Retirement Portfolio]
VTI serves as a good proxy for the entire U.S. stock market as it includes companies across all asset class categories. “It is a quintessential core stock holding, providing investors with an excellent choice for passive exposure to U.S. stocks,” according to Morningstar analyst Michael Rawson.
VB provides exposure to small-capitalization stocks, but the fund leans toward larger small-caps. Research has shown that small-caps have outperformed the market over long periods as it is easier for smaller companies to compound growth on a small base of revenue than larger companies.
VEU allows investors to access overseas growth. Most investors are too focused on American companies and forget about the investment world beyond our borders, overlooking the potential diversification qualities of including international exposure.
BND helps diminish a portfolio’s volatility as fixed-income assets have a low correlation with stocks. Consequently, bonds could perform and help support an investment portfolio as the equities market dips. The ETF provides exposure to the entire U.S. bond market, including investment-grade corporate and government bonds.
Lastly, TIP tracks Treasury bonds but also hedges against future inflation – Treasury Inflation-Protected Securities returns are pegged to the Consumer Price Index. Since TIPS are excluded from most aggregate bond funds, the ETF can complement a bond fund allocations.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.