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ETF Education

Create a Diversified Portfolio Using ETFs

Academic studies have shown that in long term, the performance of an investment portfolio depends mostly (some studies suggest ~ 90%) on asset allocation, i.e. how an investor allocates money among major asset classes.  Further, according to modern portfolio theory, an investor must seek to invest in different asset classes such that the total portfolio risk is minimized while enhancing returns. The secret behind creating a well-diversified portfolio is to include assets in the portfolio that are negatively correlated with each other. An optimal portfolio is well diversified and has the highest expected return for a given level of risk.

In the current era of globalized financial markets, investing only in the stocks of companies that operate in different areas of the U.S. economy does not result in enough diversification. Given the debt and growth problems plaguing the U.S. and eurozone, it might be a good time to look at stocks, bonds and currencies of emerging economies to achieve diversification. Commodities which are “real assets”, usually do not move in-line with stocks and bonds, which are “financial assets” for example, they tend to benefit from rising inflation. The global macro diversification strategies involve investing across markets and across different asset classes.

 We recommend that you first take a careful look at your financial situation, investment goals, risk tolerance, level of knowledge, and time horizon to determine which assets you should include in your portfolio. Following are the broad categories of asset classes you can choose from.

It can be difficult, time consuming and costly to build a diverse portfolio using stocks, bonds, commodities, currencies and real estate. However, diversified portfolios to suit different investment objectives, risk tolerances, and investment time horizons can be constructed by using low-cost, broadly diversified exchange-traded funds (ETFs) in each asset class.

Remember the allocation between different asset categories depends on your risk tolerance. Some sample portfolios using broad asset categories are shown below. The Conservative model that is heavily weighted toward fixed income is the lowest risk portfolio and seeks to minimize potential loss of principal. On the other end of the spectrum, the Aggressive Growth model which is heavily weighted towards equities seeks the most significant investment growth and may incur very large fluctuations in value. Such portfolios can be easily created using ETFs.

In addition to the ease of investing, ETFs offer many other advantages to the investors such as they can be bought or sold at any time during the trading day, can be bought on margin and can be sold short.

 

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