Stock picking is hard. You can invest significant time and effort and still not get the results you want. Just ask professional fund managers. The average fund underperforms the index by -0.41% a year according to a recent study. That’s because on average the time and effort involved in finding good stocks more than offsets the performance gain, even for professionals. That may be true for you too, last year the S&P 500 returned over 30%. Admittedly that’s a an exceptionally good S&P 500 return relative to history, but if your stock picks last year didn’t return over 30% then you could have been better off in a fund that passively tracks the index. Not only that, but you would have saved time too, time you could have spent doing something fun rather than reading balance sheets or looking at stock charts. As a result there’s a lot to be said for passive investing. Passive investing is owning a funds that tracks the index rather than trying to beat it. It may save you time and data suggests it can improve returns over stock picking even if you’re a professional.
However, the world of ETFs (Exchange Traded Funds) can be daunting too, so here are a few ideas for solid funds. The most important rule here is low fee investing. It turns out that of all the factors that predict performance of funds, fees appear to be the most accurate predictor. The lower the fee the more of your money you get to keep and as a result the returns are typically higher. At FutureAdvisor, we typically use ETFs from Vanguard, iShares or
So what ETFs should you pick? The key if you’re investing for the long term, such as for your retirement is a diversified and cheap stock fund. The Vanguard
However, the classic way to balance out the risk of a stock decline is to hold some bonds in your portfolio. Stocks and bonds are exposed to slightly different risks. Stocks are more sensitive to economic growth, whereas bonds are more responsive to interest rates and inflation, generally speaking. Stocks and bonds do sometimes move together, but generally a portfolio with both stocks and bonds offers a lower degree of risk for a similar return. Here a good example is the iShares Core US Aggregate Bond ETF (AGG). This tracks the Barclays US Aggregate Bond Index includes exposure to US government bonds, but also bonds issued by well established companies such as Verizon and Bank of America, so it holds many types of debt. Again that critical factor, the fee, is relatively low at 0.08% currently.
The one economic scenario that can derail both stocks and bonds is unexpected increase in costs, termed inflation, just as occurred in the US in the 1970s when the oil price shot up. To counteract against this issue hurting your portfolio, you should consider holding TIPS (Treasury Inflation Protected Securities). These are bonds that offer a return that includes compensation for inflation, so these assets can do well when inflation rises. A relatively inexpensive option here is The Vanguard Short Term Inflation Protected Securities ETF (VTIP) with a 0.1% annual fee. Unless you are invested for a short time period, TIPS don’t need to be a major part of your portfolio, but some exposure is helpful.
Investing outside of the US is helpful to help diversify risk of excessive exposure to the US economy when there are almost 200 countries in the world. A good option here is to consider some emerging market exposure, these economies such as Brazil, Russia, India and China can experience bigger highs and lows than developed economies. However, many of these countries also have demographic trends on their side. That is to say that they have typically younger populations, this means a greater proportion of their population will be economically active for the foreseeable future. Contrast that to the US and many countries in Europe where the population is skewing older over time. It appears that emerging markets may have an advantage in economic growth for the coming decades. Population growth is a key ingredient for economic growth. Unfortunately, emerging market stocks are more expensive to trade, so the fees here are typically a little higher. A good option is the Vanguard FTSE Emerging Markets ETF (VWO) with a fee of 0.15% holding approximately 900 stocks from around the world’s emerging markets.
Even if you can’t shake the stock picking habit, you may want to consider these ETFs as the backbone of your portfolio. This will help manage the risk of missing out on any trends that the stock you hold may not be exposed to. Of course, you can add more ETFs to your portfolio to potentially improve the risk return trade off further. For example at FutureAdvisor, we use a 12 asset class model in constructing portfolios, however adding these four funds to your portfolio is likely to help improve your trade-off between risk and return, whilst freeing up time to spend on activities that are more fun. If you already hold a set of mutual funds, the set of ETFs above may enable you to significantly reduce the fees your paying which can help your returns.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.
