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Deciding on an entire index portfolio from scratch is no easy problem. But it is an important thing. If you decide to choose your index portfolio yourself, you must be very careful about what you will invest in. Once you have chosen your portfolio, you must stick with it. If you plan to invest long-term, you may have to invest in your new portfolio for more than ten years.
Therefore, it is crucial to do this carefully. You will have to decide on your asset allocation and your international exposure. From there, you must find the indexes you want to invest in. Finally, you will have to find an Exchange Traded Fund (ETF) (or mutual fund) to invest in it for each index.
Nevertheless, choosing your index portfolio from scratch may not be necessary. And it may not even be a good idea! In most cases, you should invest a simple, broad portfolio. Making too many choices in your portfolio is market timing and is unlikely to pay off in the long term. But I still believe it is an interesting exercise. And you can design a simple three-fund portfolio from scratch and have something quite sound.
In this article, I cover in detail all the different steps involved in choosing your index ETF portfolio.
First, you need to choose the asset allocation of your portfolio.
Two main investment assets interest us: stocks and bonds. I have already talked about these two assets. But it is crucial to understand their differences to design a good portfolio.
Stocks are there for the returns part of your portfolio. They are more aggressive investments than bonds, by far. They are also quite volatile, meaning that they can move several percent in a single day. And over a year, they can have substantial increases or substantial decreases.
On the other hand, bonds are the safest part of your portfolio. They are here to stabilize it. Your bonds should perform better in bad financial times than stocks, or at least not as bad as stocks. So, if you have to leave your portfolio, you can sell some bonds when times are bad and let your stocks recover.
Contrary to what some people believe, bonds are not exempt from risks at all. It is not unlikely for bonds to go down a lot, either! They are just less likely to go down as much as stocks. In case of a systemic crash, bonds will fall as well.
In your portfolio, you can have both. But you have to decide on how much. How much of each asset is your asset allocation? If you are conservative and risk-averse, you should have a high allocation of bonds. If you want aggressive investing for the long term, you want more stocks.
One rule of thumb is to hold your age in bonds. However, I do not believe this rule of thumb makes sense. Your asset allocation is fundamental, and you should not take it lightly.
You should not forget to consider the allocation of your entire net worth. For instance, I am considering my second pillar as bonds due to their conservative investment. Therefore, I am not investing in bonds in my investment portfolio. In my broker account, my allocation is 100% to stocks.
There is another crucial thing. You should hold bonds in your home currency, ideally from your country. These bonds are supposed to stabilize your portfolio. Therefore, you do not want to have currency risk with them. Moreover, bonds are very different from one country to another.
In the United States, treasury bonds are quality bonds with a nice yield. However, here in Switzerland, bonds have negative yields. And in some countries, bonds are riskier. Therefore, you need to consider the bonds available in your country to decide on your asset allocation.
Once you have chosen your asset allocation, you need to determine the international allocation of your portfolio.
You should not hold only stocks of your own country. Your international allocation is the percentage of foreign stocks in your portfolio. You could also have international bonds and then decide on your international bond allocation. But I do not think international bonds should be in a standard portfolio. So, we should focus on international stock allocation.
Your international allocation will highly depend on your country. Generally, the smaller your country is, the more you should have foreign stocks. You want to profit from returns, not just your little country.
However, for people in the United States, the international allocation can be smaller. Some people in the U.S. do not have any international stocks in their portfolios. The United States stock market is around 50% of the world’s. Therefore, there is less interest in having a large international allocation. On the other hand, for a small country, you are losing out on many stocks if you only invest in the local stock market.
Personally, my international allocation is 80%. I only hold 20% of Swiss stocks. The rest are stocks from the entire world.
Choosing the indices
Together, your asset and international allocation will tell you what will be part of your portfolio. For instance, if your bond allocation is 20% and your international allocation for stocks is 50%, your portfolio should be made of these assets:
- 20% Local Bonds
- 40% Local Stocks
- 40% International Stocks
Now, you need to find indices to invest in for each asset. For some assets, this is pretty easy because there is only one index for this asset. However, for some popular assets, there are many indices that you can choose from. You must decide whether to use a World index or several smaller indexes. You usually want to use a world stocks index for your international stock allocation. But that is also something you can choose for yourself.
I wrote a full article on choosing between stock market indexes if you want all the information. Here are a few points you would need to consider to choose an index:
- The country of the stocks in the index. Usually, you should know that before. However, be aware that, for instance, not all European indexes invest in the same countries.
- The size of the index. This size is the number of companies in the index. Generally, a higher number indicates that the index will more closely follow the performance of the market. However, once it is very large, adding new companies does not make a significant difference since most indexes are market-capitalization-weighted.
- The size of the companies. Most indexes follow the stocks of companies of a given market capitalization. For instance, one index could follow only Large-Cap companies. It is up to you to decide what kind of companies you want to invest in.
- The style of investing. Some indexes track only value stocks or growth stocks. Some indexes track all of them together.
As you can see, even choosing a stock market index is not that easy. Even though you have a lot of choices, you should avoid being too refined. Try to have the broader index as possible. If you select only a few countries to invest in, this is market timing, and you have no idea how it will end. If you choose only small-cap companies, this is also market timing!
Be careful not to optimize too much. In the long term, over-optimization never pays off.
Choosing the ETFs
You should now have a portfolio of indexes. For instance, if you are in the United States, your portfolio could look like this at this stage:
- 20% Standard & Poor’s Treasury Bond Index
- 40% Standard & Poor’s 500 (S&P500)
- 40% FTSE All-World ex-US Index
(Note that this is only an example, I do not recommend this portfolio, it is too conservative for most people)
Unfortunately, you cannot invest in an index. You need to find a mutual fund or an Exchange Traded Fund (ETF) that follows this index. And once again, there are often several funds following the same index. Therefore, you will need to choose between different index funds.
I wrote a complete article about choosing between different index funds if you want all the details.
Shortly, here are the main things you need to consider when making this choice:
- The Total Expense Ratio (TER). How much the fund is charging on your assets is very important. You want to limit the fees to a minimum.
- The Assets Under Management (AUM). The size of a fund is an essential indicator of how well it is going. And larger funds are generally replicating the index better.
- The number of stocks. Even though several funds follow the same index, they may have a different number of stocks. For instance, they may be too small to replicate the index correctly.
- The dividend distribution. Some funds distribute the dividends directly to you, while others accumulate and reinvest them. Depending on the taxation laws in your country, one may be better than the other.
- Currency Hedging. To protect yourself against currency volatility, you can opt out for a fund hedged against your base currency. However, you will pay a premium for that.
These are only the main things you should look at when comparing two index funds tracking the same index. But there are other points that you may want to look at if you are serious about it, such as the trading volume.
Finalizing our example portfolio
We can finish the small example we started with the ETFs chosen for each of the indexes:
- 20% iShares U.S. Treasury Bond ETF (GOVT)
- 40% Vanguard S&P 500 ETF (VOO)
- 40% Vanguard FTSE All-World ex-US ETF (VEU)
Once again, this is only an example for the article’s sake. But starting from the asset allocation and the international allocation of a fictional investor, we have designed a simple portfolio of three good ETFs. By now, we have covered the entire process of choosing an index portfolio.
As you can see, choosing your passive ETF portfolio is not necessary. First, you need to choose an asset allocation for your situation. Then, you need to decide how much international exposure you want. From these two percentages, you can start to choose stock market indexes to invest in. Finally, for each index, you can choose an index fund.
This process is much easier if you choose an existing portfolio, such as the popular three-fund portfolio. The biggest problem with designing a portfolio is that it depends on where you live and your situation. The three-fund portfolio is excellent, but it will look quite different if you live in Switzerland or the United States.
Indeed, the Swiss stock market is tiny, so a large allocation to this market may be risky. Moreover, Swiss bonds have negative yields and, therefore, should be avoided. So, even if you decide on the three-fund portfolio, you still need to take local information into account.
Even though you may not have to choose a portfolio yourself, it is essential to know what you are investing in. You do not have to make all the choices yourself. But you should know what you are investing in, and you should understand why you are investing in each of your assets.
Did you ever choose an entire portfolio? What is your current investment portfolio?
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