In 1989, U.S. investors held about 93.8% of their portfolio in domestic stocks. In the past, the lack of international exchange-traded funds (“ETFs”) and mutual funds made global diversification difficult or impossible for the average investor, but these days, there’s no excuse for the so-called “home bias” common across so many stock portfolios.
In this article, we’ll take a look at how the average investor can build a global portfolio using low-cost international ETFs, as well as some automated tools that will do it for them.
Determine Asset Allocation
The first step in building a global portfolio is assessing your risk tolerance and determining the right asset allocation. Depending on your risk tolerance, you can adjust their exposure to certain classes of equities and bonds that are more or less risky than others.
Investors comfortable with taking on a lot of risk may prefer to build a portfolio that holds mostly equities and few bonds, while those that are more risk-averse may want to look at a greater percentage dedicated to bonds. In terms of asset classes, risky investors may want to consider small-cap stocks, emerging markets, and corporate bonds, while those that are risk-averse may want large-cap stocks, developed markets, and government bonds.
There are several different kinds of risk to consider. The beta coefficient is a common way to quantitatively measure an asset’s level of volatility – that is, how widely its price swings over time. In general, higher beta coefficient values suggest investments may be riskier than low values. Investors should also consider qualitative risk factors – like geopolitical risks and bond ratings – in addition to looking at quantitative measures of risk.
Finding the Right ETFs
The second step in building a global portfolio is identifying the best domestic and international ETFs to build exposure to these assets. While an ETF's expense ratio is important to consider, there are a number of other factors that shouldn’t be ignored.
The most important considerations include:
- Expense Ratio – Lower expense ratios are preferable since they automatically increase potential returns over time by reducing costs. In general, Vanguard and Charles Schwab are considered to be the leader in low-cost ETFs.
- Assets/Liquidity – Some ETFs don’t have much trading volume, which can make them difficult to buy and sell at a good price. This means that investors should make sure that ETFs they buy trade a high enough number of shares each day.
- Holdings – Different ETFs have different rules governing the stocks or bonds that they hold, as well as rules for hedging against currencies or indexing, which can have a significant impact on their churn rate and bottom line.
- Asset Class - find ETFs for each asset class in your desired asset allocation. For example Large Cap US ETFs, Small Cap Value ETFs, Emerging Market ETF, etc. This will help the investor filter out the universe of ETFs into a manageable size to make an investing decision.
Investors can find all of this information by visiting issuer websites and reading fund prospectuses. For instance, Vanguard ETFs are outlined on its website and iShares ETFs are outlined on its website. It’s important to carefully read through this literature to ensure that you have all of the information they need to make an informed decision.
Building and Rebalancing
The third step in building a global portfolio is calculating the number of shares to purchase to achieve the correct asset allocation, ensure sufficient capital to reduce commission costs, and actually make the purchases to build the portfolio.
Investors should start by multiplying their starting capital by the percentage of each allocation and then divide the dollar figure by the price per share to determine the number of shares to purchase in each ETF. In most cases, investors should try to limit their holdings to between eight and 15 ETFs in order to minimize the costs associated with buying and selling, as well as to keep their strategy relatively simple rather than excessively complicated.
After the portfolio has been created, investors may also find it necessary to periodically rebalance the portfolio’s holdings in order to maintain the same asset allocations. For example, emerging markets may outperform over the course of several months and hold an oversized position in a portfolio, which increases the risk of the portfolio. Investors may want to sell off some of those holdings and invest it in developed markets to reduce risk.
Key Takeaway Points
- The average U.S. investor holds too much domestic equity, which can put their returns at risk when domestic markets perform poorly.
- Investors can easily create a diversified global portfolio through the use of ETFs.