Asset allocation is one of the most important decisions that you make as an investor. Having the right mix of stocks, bonds, cash and commodities in your portfolio, and being well diversified within each asset class, can have a profound impact on your returns. ETFs are an easy way to gain this diversification. They are very flexible and help you gain access to sectors and asset classes that would otherwise be closed off to individual investors.
The first step in building an ETF portfolio is to figure out the right asset allocation. In general, young investors with a long time horizon should consider a more aggressive approach weighted heavily towards equities, while people who will need to withdraw their money sooner should stick to more conservative investments like bonds.
If you want to see the asset allocation of your current investments, Premium users can enter their holdings into Morningstar's Portfolio Manager. From here you can use the X-Ray tool, which will reveal your current allocation and show you how your holdings are distributed amongst stock sectors (such as healthcare and media), stock types (like high yield and slow growth), and across geographic regions.
For core stock exposure, many investors could be well served by ETFs. There are several inexpensive, broad market ETFs that track major large-cap indices, like the DJ Euro Stoxx 50. This can be a very easy way to gain exposure to the broad market. But investors who are regularly investing small amounts over time should be aware of broker fees that are incurred when buying ETFs, since these fees may push the overall costs of the investment over that of a traditional index fund.
ETFs can help you gain outsized exposure to undervalued areas of the market. Often, the short-term gyrations of the market leave certain sectors and subsectors trading for less than their intrinsic worth. Using sector ETFs in combination with your core holdings could help boost your returns over time, as we anticipate that undervalued sectors will, in the long run, converge to their fair value.
Another important role that ETFs can play in your portfolio is to provide access to alternative asset classes like commodities and currencies. These areas, which used to be available only to institutional investors and high-net worth individuals, can help further diversify your portfolio. Although most investors would want these asset classes to represent only a tiny fraction of their overall holdings, their presence in a portfolio can be helpful because they may be uncorrelated to broader stock market returns.
