Sometimes with investing, it can be hard to know where to start. Or perhaps you have a portfolio, but it’s more a jumble of different companies without much order to it. Either way, here’s a basic and inexpensive portfolio that may serve as a sensible way to ground your approach to investing.
We’ll assume that you’re investing money that you won’t need for at least a decade and that you have a stomach for the ups and downs of the market. Looking out a few years, it’s virtually certain that the markets will fall at least 30% and potentially a lot more in the coming years, similar to how the markets have in the past. Still, history also suggests that patient, disciplined investors can see robust returns if they stay the course with many well-established strategies.
Low cost Exchange Traded Funds (ETFs) can make sensible building blocks for most portfolios. They typically track an index, like the S&P 500 and generally hold the corresponding stocks of that index. Now, they do charge a fee for this. However, it’s generally low if you pick the an attractive ETF. For example, you might pay a 0.03% expense ratio for a U.S. ETF, which means you’re giving up about $3 a year to the ETF provider for every $10,000 you invest. It is worth noting though that with commission-free trading it is now possible to construct your own portfolio with hundreds of stocks at very low cost, though owning an ETF may prove the simpler option.
In picking a few ETFs to get started, it is worth considering diversification. Here owning both stocks and bonds has been the classic way to diversify. Stocks tend to do well with the economy, but bonds can hold up better should a recession hit or the markets crash. Beyond bonds, it can also pay to diversify internationally, the U.S. has had a great run of late, making this idea less fashionable, but international diversification may help manage risk in future and it has helped at various decades in history.
How much to put in stocks is a big question. Generally that determines a lot of the risk in your portfolio. Typically, experts tend to believe that longer term portfolios for those who can stomach risk and have a source of income beyond their portfolio, should have somewhere between 50% and 80% in stocks. Here we’ll assume a 60% allocation to stocks. Broadly, speaking if the markets fell 30%, which is quite possible, then this portfolio would lose around 18% of its value. Of course, the advantage of stocks is that they can see strong gains should the economy perform well and valuations hold or improve.
Then it is worth flagging just how expensive the U.S. stock market appears today. That’s relative to both other international stock markets and its own history. The S&P 500 trades at 24x earnings, compared to a longer term average of closer to 15x earnings. Looking overseas, developed markets in Europe are currently on 19x earnings and emerging markets on 15x earnings.
24x to 15x may not seem like a big deal, but it would require an almost 40% drop in the U.S. market to return to a 15x valuation all else equal. Yes, the U.S. has a lot going for it and U.S. companies have international exposure, but I worry that U.S. valuations are on the high side and historically that has not ended well. As a result of this it may make sense to hold less U.S. exposure in favor of other parts of the world.
Therefore, it may make sense to consider the Vanguard Total International Stock ETF for your portfolio. This gives you global exposure outside the U.S. including Europe, Japan, emerging markets such as China and many other parts of the world. It currently has an expense ratio of 0.09%, or $9 for every $10,000 invested per year.
For U.S. exposure, The Vanguard Total Stock Market ETF has an attractive 0.03% expense ratio holding a broad set of U.S. companies. You don’t necessarily have to use Vanguard funds, though they are often well-regarded as being investor friendly. iShares, Fidelity and Schwab among others also offer some attractively priced and well regarded ETFs.
You could chose to split your U.S. and foreign exposure 50/50. If you are concerned about U.S. valuations you could even hold more international investments than those in the U.S.. If you did assume a 50/50 split, then with a 60% stock allocation that would imply 30% to a U.S. stock market ETF and 30% to an international stock ETF.
Finally, how to round out your portfolio with some lower risk assets is a trickier question than it has been in the past. This is simply as yields on bonds are so low relative to history. There are various ETFs that track the U.S. bond market such as the Vanguard Total Bond Market ETF or iShares Core U.S. Aggregate Bond ETF. These currently yield a little over 2% with expense ratios of 0.04% and 0.05% respectively. It’s a fair bet than in weak markets bonds will hold up better than stocks based on history, though the low yields today do potentially pose a risk should inflation resurface. As such you might also consider some other potential diversifying investments for your portfolio such as commodities or precious metals, which can also be owned via ETFs. Nonetheless, here for a basic portfolio we’ll keep it simple and assume a 40% allocation to a diversified bond ETF.
Now, with 30% domestic stocks, 30% foreign stocks and 40% bonds as expressed through low-cost ETFs you have a basic template for a portfolio. How you chose to modify it from there is up to you, but that presents you with a reasonably diversified and low-cost way to begin long-term investing.
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