While I'm an avid individual stock investor, it's important not to overlook the wealth-creation potential of low-cost exchange-traded funds (ETFs). They can be a great supplement to a portfolio of individual stocks or a great way to invest all by themselves -- especially the low-cost index fund variety.
With that in mind, if I could only use five ETFs to create an investment portfolio to last for decades, here's a list of the funds I'd choose.
The five index funds I'd use to create a portfolio
There's no perfect combination of five ETFs. I'm generally a fan of Vanguard's funds due to their low costs, but there are great ETFs from other companies, such as Charles Schwab, BlackRock, and others.
If I were to form a long-term investment portfolio using only a handful of ETFs, I'd want to use a general S&P 500 index fund to form a portfolio "backbone." I'd also want exposure to small-cap stocks, international stocks, and fixed income. So here are the five Vanguard ETFs I'd use:
- The Vanguard S&P 500 ETF (VOO 0.08%) is an S&P 500 index fund, aiming to match the returns of the benchmark index over time. Since 1965, the S&P 500 has averaged a 10% annualized return.
- The Vanguard Small-Cap ETF (VB 0.32%) gives exposure to smaller companies. The S&P 500 is a weighted index of large-cap stocks, so its performance mainly depends on the largest U.S. corporations. This one adds small caps, giving more diversified exposure to the U.S. stock market than an S&P 500 index fund alone.
- The Vanguard International Stock ETF (VXUS +0.25%), as the name implies, invests in an index of companies based outside of the United States. I'm a fan of having some international exposure, and a basic index fund like this can be a great way to get it.
- The Vanguard Real Estate ETF (VNQ +0.22%) adds diversification and income to the portfolio. This is an index fund mainly composed of real estate investment trusts, or REITs. Not only do these stocks pay above-average dividends, but they tend to be less volatile than the S&P 500.
- Finally, the Vanguard Total Bond Market ETF (BND 0.15%) tracks an index of fixed-income securities (bonds) with exposure to corporate and government bonds of various maturity lengths. Fixed-income securities tend to provide consistent income and aren't nearly as volatile (generally) as the stock market.
How I'd allocate my money
As a general rule of thumb, I subtract my age from 110 to determine the percentage of my assets that should be in stocks, with the rest in fixed income investments. I'm in my early 40s, so this means that I should keep about 70% of my money in stocks. I tend to think I have a somewhat high level of risk tolerance, so my actual stock allocation is closer to 80%.
NYSEMKT: VOO
Key Data Points
Of the five index funds I listed, four are stock-based ETFs. I'd put about half of my stock allocation in the S&P 500 index fund, with the rest equally divided among the other four. But it's important to periodically take stock of how your investments have performed, as well as your age, and rebalance accordingly.
How much can you expect from a strategy like this?
There's no way to accurately predict how any investments will do, especially over shorter periods. The stock market has historically produced returns of about 10% annualized over multidecade periods, and fixed-income investments have historically produced total returns in the 4%-5% annualized range.
It's reasonable to expect a long-term rate of return of around 7% from a balanced strategy like this. To put this into perspective, if you start when you're 30 and invest $5,000 annually into an index fund portfolio like this averaging 7% annualized returns, you'd have about $700,000 by the time you're 65. If you start when you're 25, this simple, hands-off strategy could allow you to retire a millionaire.
As Warren Buffett said, "It is not necessary to do extraordinary things to achieve extraordinary results." And that's true in investing if you have two things -- rock-solid ETFs and time.
