Having the right mix of stocks, bonds, cash, and commodities in your portfolio, and being well diversified within each asset class, can have a profound impact of your returns. ETFs can be an easy way to gain this diversification. They can be cheap, flexible, and tax-efficient and may help you gain access to sectors and asset classes that would otherwise be closed off to individual investors.
The first step in building an ETF portfolio is to figure out the right asset allocation. You will consider your theoretical exposure to cash, bonds, large-cap stocks, medium/small-cap stocks, and foreign stocks. In general, investors with a long time horizon should consider a more aggressive approach weighted heavily toward equities, while people within a few years of needing their money should stick to more conservative investments.
After making your decisions and with help of asset allocator tools provided by many financial website, you can know the chance that you will be able to meet your financial goals given how much money you already have invested and how much additional money you intend to invest monthly.
Armed with your asset allocation decisions, you can use ETF screeners provided by financial portals, such as Morningstar and Yahoo Finance, to discover which securities will help you achieve your goals.
For core stock exposure, many investors could be well served by ETFs. There are several inexpensive, broad market ETFs that track major large-cap indexes, like the S&P 500. This can be a very cheap way to gain exposure to the broad market, but investors who are dollar-cost averaging (regularly investing small amounts over time) should carefully watch broker fees that are incurred when buying ETFs, as they may push the overall costs of the investment over that of a traditional index mutual fund.
Another important role that ETFs can play in your portfolio is to provide access to alternative asset classes like commodities and currencies. These areas, which used to be available only to institutional investors and high-net worth individuals, can help further diversify your portfolio. Although most investors would want these asset classes to represent only a tiny fraction of their overall holdings, their presence in a portfolio can be helpful because they can be uncorrelated to broader stock market returns.