How to Choose Your Best ETF Portfolio

Are you ready to start investing in the stock market, but feel overwhelmed trying to find the best ETF portfolio? It’s easy to get stuck in analysis paralysis when looking at the number of investment choices available.

Time in the market is, by far the biggest predictor of return so it is important to get in promptly. Investing regularly ready, and staying invested for the long term are the next important factors.

Choosing a sensible portfolio is far more important than finding the best ETF.

The good news is that investing in the stock market is pretty simple, if you follow the evidence. Passive investing will outperform active strategies most of the time. It makes no sense to start investing with trying to stock pick when you can build a diversified passive portfolio pretty easily. Most will stick with this approach exclusively. Those that want to dabble in the world of active stock picking should build their passive portfolio first.

But even with a passive investing strategy, there is the challenge of designing an asset portfolio. Selecting the best ETFs to invest in is a time where beginners can gets stuck, and delay investing.

This article will step you through picking a reasonable asset allocation, and selecting your investment funds.

Are you Ready to Pick the Best ETF Portfolio?

This article is aimed at those who have an investment plan (even if basic) have saved an appropriate emergency fund for their situation. It is aimed at those for whom investing outside superannuation makes more sense than inside. To find out where you stand, check out the mega step by step guide to building wealth.

First you need to consider whether investing in the stock market is appropriate for your situation. Investors should have at least a basic emergency fund saved. They also need bare minimum of 5-7 years that they are happy to keep investments in the market.

Given the unpredictable volatility of the market, this is rarely the place to save your home deposit. Only invest money that, if you were to lose 50% of the value of your investment, you would be willing to wait out up to 5 years for the market to recovery.

I confess, I did invest savings intended for an investment property. It was a gamble, given I only had a two year time frame. Were the market to drop, I was willing to wait for it to recover and delay property purchase.

For me, this paid off, but could easily have delayed my real estate investment plan. If you want to buy a property (and don’t want to wait 5 years), be a little more patient and invest in a savings account, offset or term deposit.

To start with a traditional stock broker, you probably want at least $2000 to invest at a time. The brokerage cost of each investment is between $5 and $20 with an online broker (to sell and again to buy). As a result, it is worth building up savings and investing less regularly to save on costs.

Consider a Microinvestment App if You Don’t have $2000 to Invest

If $2000 seems far too much to save, or you really want to invest with every pay, consider starting with a microinvestment app.

Many of these charge no brokerage, but often charge a management fee as a percentage of your investment portfolio.

They are more cost effective for small and frequent investments. They also limit investment choices to a smaller selection, which helps beginner investors decide.

Once you know how much you want to invest at what regularity, compare the fee structures to work out which will be best for you.

Don’t be fooled into thinking it’s not worth it until you have $2000 to invest. Small amounts invested regularly can grow surprisingly quickly, so it is worth starting with whatever you have.

Once you have enough, you can graduate to a regular online broker. I started with a RAIZ account, before graduating to broker accounts with Commsec and Pearler.

Micro-investing is also helpful for learning and confidence building in investing. Whilst micro-investing, I experienced multiple market drops, hyped by the media to sound like the end of the world.

It was nerve racking, and I was tempted to withdraw my cash several times. Each time, the market recovered, and I grew more confident in ignoring the media hype and keeping my money invested.

Choosing an Asset Allocation

Asset allocation refers to the broad categories you invest in, in what proportions. The main categories of investments are

  • Shares
  • Real estate
  • Bonds
  • Cash and other fixed interest investments

Your asset allocation will be affected by your age and risk tolerance. There is no ideal asset allocation.

There are traditional rules of thumb for the proportion of stocks vs bonds, which may be a starting point.

100 minus age = % stocks

Often considered too conservative, now we are living longer. A new rule of thumb has been proposed

120 minus age = % stocks

Investors should write down an ideal target asset allocation to refer back to and invest to achieve. You can review your asset allocation, and should at pre-determined points, perhaps every 5 years.

Stock market losses require significant time and growth to recover. A 50% drop in the market, requires 100% growth to recover back to it’s former high.

The closer you are needing to withdraw money from your investments, the more punishing bear markets are, and the less risk investors are generally advised to take.

Asset allocation review should only occur when the investor is calm and the market steady. This should not be changed in the middle of a market crash.

Assessing Risk Tolerance

It is actually really hard to understand your risk tolerance without experiencing being invested. There is a fantastic explanation of risk in this article. There are online risk tolerance calculators that reflect what you believe your risk tolerance is, but not how you will react to a market crash.

The media whips into a complete frenzy, and every article, podcast and barbecue discussion tend to be dominated by the disaster, and how much worst is to come.

Media predictions, in the 14 years I have been observing, seem to be completely uncorrelated (perhaps even negatively correlated) to actual outcomes.

At all costs, you want to avoid panicking at the bottom of a bear market and selling. Many investors do this, and it is the worst possible outcome for your portfolio performance. If in doubt, assume you have a lower risk tolerance than you think, most people do.

Assessing Risk in Each Investment

Risk has to be assessed for each investment you consider purchasing. This should be considered before being seduced by suggested returns

With great risk comes great returns. But also with great risk comes complete financial devastation.

Aussie Doc Freedom

You want to optimise your returns for minimum risk.

Risk in investments is often portrayed in a graph as shown

Theoretical risk profile of investment classes

Shares are portrayed as highest risk, followed by property, then bonds and cash.

But there are Different Kinds of Risk

Volatility and risk of capital loss are often lumped in together as investment risk. The risk of losing your entire invested amount altogether, in my opinion, is very different from having to be able to tolerate short term volatility before recovery of a market.

Cash, considered the lowest risk actually has the largest risk of losing value relative to inflation. Inflation is the amount that a cost of goods and services increase annually. It varies with economic conditions, but invariably increases faster than the interest rate available on “high interest” savings accounts.

In real terms, cash allocations in your portfolio are losing value over time. This risk is known and predictable. Cash should be kept to cover short term needs and emergencies. It is not really an investment.

Property is generally purchased utilising leverage, which increases the risk of investment. This is likely to be higher risk than purchasing a broad based international passive index ETF. Purchasing individual shares exposes the investor to the risks of that underlying company, likely more risk than the property investment.

In summary, risk is not as simple as the graph above implies. Risk needs to be considered based on individual investments. Consider the risk of capital loss initially, and separately from volatility.

Buying the wrong asset, be it with property or shares (or even “junk bonds”) is associated with significant risk or capital loss. Minimise this risk ruthlessly. Extra risk should only be taken on if fully understood, Greater risk must be rewarded with greater return.

Detailed Asset Allocation

Within the main categories described above, there are subcategories you will also need to decide upon

Stocks

  • Australian stocks
  • International stocks
  • Other eg commodities, gold etc

Bonds

  • Government bonds
  • Corporate bonds

Real Estate

  • Australian residential physical or REIT
  • Australian commercial physical or REIT
  • International physical or REIT

Cash and fixed interest

  • Term deposits
  • Cash

Diversification

I think most readers will have an understanding of diversification.

Don’t put all your eggs in one basket is a well known phrase, and easy to understand.

If you have researched, and believe Australian Real estate is the best way to build wealth over the long-term, it is still wise to have other investments. No-one can predict the future. Unimaginable events could lead to Australian real estate losing significant value and never recovering.

This would be a disaster if you have invested in Australian real estate as I have, but less of a disaster if you at least have other investments.

Owning investments in all major classes and purchasing broad passive ETFs achieves a good degree of diversification quickly. Of note, the Australian stock market is tiny, and heavily concentrated in the top 10 stocks. Investments in only Australian ETFs is not diversified.

Correlation

Correlation refers to the amount investment returns tend to move with each other. The Australian stock market tends to follow the US. Consequently, the two are positively correlated. Choosing assets with low correlation means your overall portfolio is more protected against major losses.

Going back to our example above, international stocks have a low correlation with Australian real estate. I have chosen to increase my exposure to international stocks to compensate for my over exposure to Australian property.

Here is a table of historical correlation.

Superannuation Asset Allocation

Don’t look at your portfolio outside superannuation in isolation. Particularly if your superannuation balance is already significant.

If you are happy for your super fund to continue managing your investments, check your investment options.

What is your asset allocation inside super? Does it suit your risk tolerance, age and preferences? Do you need to change this?

Are you fairly happy with your superannuation portfolio, but would prefer to tweak the asset allocation?

Tweaking your Portfolio

Taking control of your superannuation often involves a significant increase in fees. An easy work around is to use your investments outside superannuation to move your overall asset allocation towards your ideal scenario.

For this reason, my asset allocation outside superannuation is simple. I wanted to invest in physical residential real estate, using leverage to produce equity over the years. I would also like a slightly higher stock vs bond/fixed interest allocation than my super fund allows.

As a result of my two investment properties, I am over exposed to Australian risk. I have chosen to increase my exposure to international equities, which have a low correlation with Australian property.

Stocks

Australian vs International

Within the shares allocation, you need to decide an allocation to Australian shares vs international. Australian investors traditionally love domestic equities due to franking credits, not available on dividends from overseas.

The Australian ASX only represents around 2% of the global market. Most investors down under will be excessively concentrated in Australian shares.

The Australian share market is also dominated by just a handful of companies, making even the ASX 300 relatively concentrated. The ideal percentage of international equities is under debate. Passive Investing Australia has some useful guidance. Read the article, pick a number and move on.

Hedged vs unhedged

With your international equities, will you pay extra to “Hedge” currency risk? If the Australian dollar is strong when you want to withdraw, you will benefit from the investments being hedged. If the Aussie dollar is weak, you would have been better off unhedged.

Unfortunately there is no way to tell the future of how the Australian dollar will fare. If you plan to retire outside Australia, there is little sense in paying to hedge to a currency you may not even be using. If you plan to retire within Australia, it probably depends on the state of the Aussie dollar at time of investment, and personal preference.

Read more here. Again, choose hedged or unhedged or 50:50 and move on.

Passive vs Active

Passive investing has become incredibly popular over recent years. It’s simple, low cost and anyone can do it. Amazingly, passive investing appears to have beaten laborious and expensive investment management most of the time.

It’s easy for beginners to assume beating the index should be easy. Evidence tells us it’s very hard, even for full time professional investors. I doubt anyone would argue that a passive strategy is at least a good way to start an investment portfolio.

Not all ETFs are passive, or broad index funds. Listed investment companies (LICs) are Australian actively managed funds, but at comparably low fees. Check out the article on ETFs vs LICs if you want to read more about the differences.

Capital Growth vs Income

All investments can be categorized as capital gain, income focussed, or mixed. Early in your investing journey, a capital gains focus is more efficient because it isn’t taxed.

Eventually you will need your investments to produce an income. With the stock market this is easy, withdrawing your investments is essentially the same as allowing a dividend to be paid out.

With property, investors often end up “asset rich, cash poor” unless they pivot to income investments once they have accumulated enough equity.

Many investors like dividend investing. I feel this is better suited to low income earners (they benefit far more from Franking credits). I like the approach of efficiently building equity using capital growth before pivoting more into stocks that can be easily withdrawn as income.

Past Performance in Choosing the Best ETF

Past performance should largely be ignored when comparing ETFs or super funds. Chasing last year’s top performer has been found to be a great predictor of poor performance the next year. Past performance does not predict future performance. Repeat ad infinatum. Seriously! Ignore it when choosing the best ETF.

Fees in Choosing the Best ETF

Fees are the only predictable part of performance. Given two similar ETFs you are torn between, the lower cost fund is likely to perform better.

ETF fees are commonly 0.2-0.4%. If you are paying more than 0.4% there should be a very good reason for this.

Choosing the Best ETF Portfolio

Find Three ETFs that suit your requirements.

Make a shopping list such as:

  • Broad passive Australian index fund ETF
  • Broad passive international hedged index fund ETF
  • Australian government bond ETF

Check out these three websites and list best ETF that match your list:

Vanguard

Ishares

Ignore anything “synthetic” or “derivative”. You are looking for passive funds that track a broad index. Choose the lowest cost ETF. Read the product disclosure statement to check for small print.

The size of the ETF becomes relevant if the liquidity may be an issue – small ETFs without many investors could be difficult to offload when you want to sell. This shouldn’t be an issue with broad ETFs with the major providers.

“Tactical tilts” using narrow ETFs aimed at one industry (eg tech) should only be considered by experienced investors after significant research. Keep it simple to begin with, you can always add more complexity later.

 

Physical Real Estate will Screw Up Your Asset Allocation

Do you want to include real estate investing? Whether physical investment properties, or real estate investment trusts (REITs), the ideal percentage of your final portfolio should be considered.

Physical real estate appeals to me, because the data tells me it has a low correlation with the stock market. If there is another 50% + drop in the stock market after I retire, I do not expect rental income to immediately drop. It may decrease eventually, but it weakens my reliance on stock market returns for income.

REITs seem an ideal way to invest in real estate, except the listed ones are highly correlated with the stock market.

Physical real estate screws up your portfolio asset allocation completely. As such a lumpy asset, spending $500,000+ on a single property will make investors overweight on property in their portfolio.

Asset Allocation with Property Investments

My approach to this, is to design my ideal portfolio prior to retirement, and purchase real estate towards that goal.

It is then easier to remove the real estate from the asset allocation. Out of the rest, I work out the proportions of stocks, bonds and other asset allocations.

Find a StockBroker

You will need to choose a stock broker in order to buy your 1st investment. Check out the stock broker article.

Rebalancing

To maintain your asset allocation, investors are often advised to regularly rebalance. Find out how to perform portfolio rebalancing.

Keeping your investments close to the target asset allocation, means you are forced to buy the assets that are doing poorly and sell (or not buy) those that are performing well.

This is in opposition to human nature, which is out to make sure we underperform, by encouraging to buy when the price is up, and sell when assets are on sale.

If you can purchase (instead of selling) investments to maintain asset allocation, you will save on brokerage. But at times of major market movement you may need to sell.

Choosing the Best ETF and Asset Allocation

Which ETFs did you choose? Comment below and let us know why you made the choice you did.

Aussie Doc Freedom is not a financial adviser and does need offer any advice.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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