Want to know the magic formula for retirement investing? So, maybe magic is too strong a word, but there is an investment approach that's easy to implement and works as well for novice investors as it does for savvy professionals. It involves investing in exchange-traded funds (ETFs). When you buy an ETF, you are purchasing shares of an entire portfolio of assets -- similar to a mutual fund. But unlike mutual funds, ETFs are traded on a stock exchange and their share prices fluctuate throughout the day.
Here are four compelling reasons why ETFs are the perfect building blocks for your retirement portfolio.
1. ETFs are diversified
ETFs hold various assets, so they're naturally diversified. Diversification is critical to your success as a retirement investor, because it spreads out your risk and smooths out volatility. If you only invested in a single company, your portfolio balance would shift with each and every movement of that company's share price. And, if that company were to run into tough times and go belly up, it'd take your retirement savings down the drain with it.
That's why your portfolio should be diversified with at least 20 different positions -- so that if any one of those positions loses all of its value, your portfolio can only dip 5%.
That level of diversification is easy to achieve with an ETF. Many ETFs track financial market indexes and hold hundreds, if not thousands, of positions. The Vanguard S&P 500 Index ETF (VOO 0.28%), for example, has 510 large-cap stocks in its portfolio. When you purchase a single share of VOO, you get exposure to all of them.
There is a caveat, though. Most ETFs are diversified within a single asset class, which is only part of the diversification picture. Back to the Vanguard S&P 500 Index ETF -- yes, it does have 510 positions, but every single one is a large-cap stock. To be fully diversified, you should have exposure to other asset classes, like fixed income and cash equivalents.
But guess what? You can do that by combining ETFs. iShares Core U.S. Aggregate Bond ETF (AGG -0.15%), for example, provides exposure to more than 8,200 U.S. investment-grade bonds.
2. ETFs are easy to manage
It only takes a handful of ETFs to build a balanced portfolio. Consider the two ETFs referenced above, VOO and AGG. Combined, they give you broad exposure to U.S. stocks and U.S. bonds. You could then add in shares of iShares Core MSCI Total International Stock ETF (IXUS -0.32%) or a similar fund to diversify into international equities. That's all many investors will need, and it consists of just three funds.
You could take this approach much further, though. There are ETFs for mid-caps and small-caps. There are sector ETFs, gold ETFs, and even real estate ETFs. Whatever type of exposure you need, you can probably find it with an ETF.
Let's say you construct your ideal retirement portfolio out of four ETFs. Your target allocation across those funds is 40% U.S. stocks, 30% international stocks, 20% U.S. bonds, and 10% international bonds. Over time, those funds will grow at different rates and you'll need to make adjustments to get back to your targeted allocation. That rebalancing process is far easier to manage when you're working with four funds rather than hundreds of separate positions.
3. Most ETFs have low fees
Fund fees are communicated to investors in the form of an expense ratio, which represents the portion of your investment that's needed to cover the fund's operating costs. Expense ratios are important because they affect returns. A lower expense ratio allows a higher portion of the fund's earnings to flow through to investors. Higher expense ratios do the opposite; they drag down shareholder returns.
Expense ratios can range from .01% to more than 2%. Most ETFs are at the lower end of that spectrum. VOO, for example, has an expense ratio of .03%. AGG has an expense ratio of .04%. These funds keep costs low because they're passively managed, meaning there's no dedicated fund manager. Dedicated fund managers usually have the job of trading often to outperform the market. Passive fund management instead accepts market-level returns in exchange for lower operating costs. Given that fund managers don't actually beat the market consistently, it's a pretty good trade-off.
4. Index ETFs keep pace with the market
Index ETFs are constructed to mimic the performance of an underlying index. No index fund will achieve exactly the same return as the underlying index, but it should be close in a fairly consistent way. And that near-market-level return is a beautiful thing for investors. Whether the market is up or down, your index fund goes right along with it. If you believe that short-term market volatility always gives way to long-term growth -- and you should -- index funds are a reliable way to benefit from that growth over time.
The low-stress investment
ETFs provide easy, cost-efficient access to diversification and near-market-level returns. And that's all you really need to grow your retirement savings from modest monthly contributions to a sizable nest egg over the long haul. It's not exactly magic, but it is a formula that works.