Exchange-traded funds (ETFs) have become popular among new investors because of their simplicity. However, based on my experience of reviewing several portfolios for my students and clients, I have noticed that the most common mistake that new investors make is having too many ETFs in their portfolios.
ETFs contain multiple stocks and bonds from different sectors and geographical regions. The primary objective of an ETF is to help diversify your portfolio and minimize your risk. But when you have too many ETFs in your portfolio, you run the risk of over-diversification, which could cause your investment portfolio to underperform.
In today's issue, we will learn how to properly stack ETFs in your portfolio to help maximize your returns and minimize your losses.
THE STACK
As an investor, it's crucial to learn about risk management. The most effective way to manage your risk is through diversification.
To achieve a well-diversified portfolio, you need to spread your risk across these three key areas:
Diversify by asset class
Diversifying by asset class involves investing in a combination of equity and fixed-income assets.
Equity assets refer to investments where the investor owns a part of the company, typically in the form of shares. The company uses the investor's capital to grow its business and make profits, which are then shared with investors. Examples of equity assets include stocks and ETFs that contain stocks. Equity assets are vital because they help with capital appreciation and contribute to the growth of your portfolio.
Fixed-income assets are investments where an investor loans money to a company or government for a specific term. At the end of the term, the investor receives their capital plus interest. Fixed-income assets help to preserve your capital from losses and are a good complement to equity assets which are typically more volatile. Examples of fixed-income assets include bonds and ETFs that contain bonds.
Diversify by sector
Certain sectors of the economy are stronger than others. For instance, the technology sector is the strongest in the US, while the finance sector is the strongest in Canada.
It's never a good idea to invest all your money into one particular sector, even if it is the strongest one because different sectors have varying levels of volatility. By diversifying your investments across multiple sectors, you can mitigate the risk of losing everything if one sector goes down.
Here’s a list of the different sectors of the economy:
Diversify by country
Investing all your money in one country can be risky because some countries have more stable economies than others. By diversifying your investments across several countries, you can ensure that if one country experiences an economic downturn, you will be protected by the stability of the other countries in your portfolio.
How do you build a diversified portfolio using only ETFs?
To build a diversified portfolio of ETFs, it's best to use broad-based ETFs.
A broad-based ETF contains multiple stocks of companies from various sectors of the economy. Rather than selecting an ETF in each industry, you can purchase an ETF that covers numerous sectors at once.
Here are the four broad-based ETFs I recommend every investor should have in their portfolio:
1. Canadian Total Stock Market ETF
Canadian total stock market ETFs are ETFs that invest in all the companies in the Canadian stock market. They typically have a mix of large-cap, mid-cap and small-cap companies. They also contain companies from all the major industries in Canada. The beauty of these Canadian total stock market ETFs is that the top companies in the fund are usually the strongest companies in Canada, which will help in the growth of your portfolio.
Examples of ETFs that track the Canadian total stock market:
2. US Total Stock Market ETF
The US total stock market ETFs invest in the entire US market. They typically have a mix of large-cap, mid-cap and small-cap companies across various sectors in the US economy.
Alternatively, you could invest in an S&P500 index ETF. The S&P500 index is a list of 509 of the top companies in the US and represents 80% of the US market. The S&P500 is used to track the performance of the US market.
Examples of ETFs that track the US total stock market:
Examples of ETFs that track the S&P500:
3. International Stock Market ETF
International stock market ETFs invest in regions outside of North America, such as Europe, Australasia and the Far East (EAFE). One of the most popular international indexes is the EAFE index offered by Morgan Stanley Capital International (MSCI EAFE Index).
Examples of ETFs that track international stock markets:
4. Fixed Income ETF
Fixed-income ETFs contain high-quality bonds from various companies, governments and municipalities. You could choose ETFs that invest in Canadian bonds or a mix of Canadian and US bonds.
Examples of Canadian fixed-income ETFs:
Once you have chosen your four ETFs (one from each of these categories listed above), you will have built a solid foundation and an investment portfolio that can weather market fluctuations.
It is important to note that when you choose a broad-based ETF from one country, you do not need to add another ETF from the same country because they will likely have the same top companies, which will make your portfolio redundant.
For example, VUN and VFV both contain 9 of the same companies in their top 10 holdings. So, holding both of them in your portfolio isn’t necessary.
What to look for when picking an ETF
Recommended next reads
Now that you know what four ETFs you should have In your portfolio, the next question on your mind is probably, how do I know which one to pick? I will cover what to look for when picking an ETF in next week’s issue. So make sure you are subscribed to our newsletter so you can get it directly in your inbox!
THE TOOL
Here are some websites where you can find and research ETFs
Some of my go-to ETF fund managers are:
THE ACCOUNTABILITY
Review the ETFs in your portfolio and ensure you don’t have multiple ETFs that track the same country or industry.
A good way to verify this is to compare the top 10 holdings. If more than five of the top ten companies are the same, you must eliminate one of those ETFs from your portfolio.
THE COURAGE
THE KNOWLEDGE
Volatility
Volatility refers to the rate at which the price of a stock increases and decreases over a given period. The more the price fluctuates, the higher the volatility.
The volatility of a stock is also known as the Beta. Stocks that have a Beta above one are considered volatile.
Small-cap
A small-cap stock is a stock of a company with a market capitalization (total market value) between $250 million and $2 billion.
Mid-cap
A mid-cap stock is a stock of a company with a market capitalization between $2 billion and $10 billion.
Large-cap
A mid-cap stock is a stock of a company with a market capitalization between $10 billion and $200 billion.
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Thank you for reading today's issue of The Stack. If you found this helpful, please forward this to a friend who could benefit from it and reply, letting me know your biggest takeaway.
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Keep Stacking!
Eduek 💙
