Step 2
Compose Your globally diversified Portfolio

Diversification is the only free Lunch

In the previous step Smart Money Diary has described how to establish your monthly saving rate and now you have started saving money on a regular basis. But what should you invest in?

The first important concept to apply is diversification. Simply said: do not put all your money into one basket (e.g., investing all into Amazon or Tesla shares). If something goes bust, you will loose everything. Even a mix of ten different blue-chip stocks is not sufficient diversification. Besides, picking the right candidates is time consuming and success very limited. Remember, even the funds of professional stock pickers lag behind their benchmark indices and they should have all the tools to run successful stock picking.

Here passive investing via low-cost index funds kicks in. In the form of very liquid exchange-traded funds they provide an excellent vehicle to broadly diversify over different asset classes by simply replicating indices at low cost. Every day the stock-exchange is open they can be bought or sold by a click of a button - very convenient. Still, the question remains: into which of the thousands of products available to invest?

Best starting point is an overview of different asset classes, characterised by liquidity, volatility and expected return. Bear in mind that this overview is very general and within the asset classes there are differences - also over time, for example due to macroeconomic events or regulations there might occur changes.

Source: Smart Money Diary - Dec 2022

Different Asset Classes and their Level of Risk

From a risk point of view above asset classes can be divided into "risk-free" and more volatile assets. Under "risk-free" there are listed Cash (for example, time deposits are guaranteed up to 100k EUR in the EU) and short-term government bonds with a duration <3 years (less sensible to national banks' interest hikes) and best credit risk ratings between AAA and AA. Even if assets are called "risk-free" they are not 100% without risk because even the 100k EUR security for bank deposits will be worth-less in case of a severe melt-down of the banking system. Also, highest-rated government bonds could face a default - even if likelihood is extremely low - but cannot be totally excluded.

This risk-free component in a portfolio serves as safe heaven during stormy market periods and not as yield generator. Depending on personal risk-appetite and capability to withstand temporary heavy losses on paper (see graphic below) the portfolio mix usually consists of exchange-traded funds on broad equity indices (generating the yield, but coming along with higher volatility) and of time deposits or government bonds with investment grade rating.

MSCI World
31.10.2007 - 09.03.2009

-57.46%
max.
drawdown

over 16 months period

Source: MSCI.com - Index Factsheet as of Nov 2022

Usually, bonds went down significantly less or even up when shares went down (negative correlation) as it was also valid for government bonds during the pandemic in 2020 (see comparison below - corporate bonds also went down as the world stock market did but less sharp).

Source: Smart Money Diary - Dec 2022

For the first time, in 2022 bonds have shown positive correlation with shares since leaving low-interest rate environments due to national banks' interest hikes for fighting higher inflation, meaning both asset classes lost at the same time. In such environment, bonds with very short duration or even time deposits would have been a better choice. Time will tell if that was only a short-term hick-up (during rate hikes) - since we are talking about investing periods of 20+ years.

Average past annual Returns of different Portfolio Allocations

In order to give a taste of which return different portfolio allocations between bond / shares have generated in the past (cannot be guaranteed for the future), please check out the following overview from Vanguard.

Bildschirmfoto 2022-12-17 um 15.00.38.png

Accordingly, often used portfolio allocations of 60/40 (shares/bonds) have generated an average yearly return of 8.8% or 9.2% for a 70/30-allocation between 1926 and 2019. A 100% stocks-based portfolio would have provided an annual return of 10.3% in average, but with significant higher max. losses (-43.1% max annual loss vs. -30.7% (70/30) or -26.6% (60/40). To be clear, past performance cannot predict future returns.

Selection Criteria for composing a globally diversified ETF Portfolio

At first sight, the information shown above might be overwhelming for the investors who just want to start. And the imminent question will be what should I invest in - how to choose the right ETF for generating my long-term wealth?

Here some basic selection criteria proposed by Smart Money Diary for composing a globally diversified portfolio with ETFs:

Composition of Index:
Consider regional diversification (e.g., North America, Europe, Japan etc.) as well as full range of company's market capitalisation categories (large - mid - small caps).
The broader the index, the better. EuroStoxx 50 or FTSE 100 are not sufficiently diversified for your purpose - rather EuroStoxx 600 or FTSE Developed Europe.
Assets Under Management:
Minimum 300 mn EUR - and you will automatically end up investing into major and well-known players like Vanguard, BlackRock (ishares) or SPDR.
If the volume is smaller the risk for closing the funds is higher. That would only cause time and effort for the investor to choose another ETF.
Physical Replication of the index:
meaning the funds holds the asset (e.g., Microsoft, Apple shares) and is not using sampling techniques via financial derivatives (synthetic replication).
Total Expense Ratio (TER):
the lower the better as it impacts the return (e.g., below 0.3% p.a. is achievable). While these fees are not paid directly by the investor, they lower the performance of the ETF
Tracking Difference:
Measuring how well an ETF is replicating a benchmark index. The lower, the better according to empirical studies. Even negative TD are possible, if the ETF managed to generate additional return (e.g., from lending shares).
Accumulating vs. Distributing:
Accumulating ETFs reinvest automatically all dividends and might have a positive tax effect (depending on your personal tax situation) while distributing ETFs generate mostly quarterly cash-flows which have to be individually reinvested in order to benefit from the compound effect. Nevertheless, in case all money has been invested it can be nice to receive such cash-flow for financing regular rebalancing transactions.
Avoid Currency Hedging - because hedging costs money and over the very long run currency impact is less significant. Some brokers allow to have foreign currency brokerage accounts - for some investors it wouldn't be so bad to hold USD next to EUR.

Three easy to implement Ideas of a globally diversified ETF Portfolio

Applying above listed selection criteria, let's look at three ideas (not to be understood as advice or suggestion) of different portfolio set-ups.

1. The Simplest - One globally diversified Equity ETF - 100% Stocks

Choose one of the following indices covering the entire world, save regularly (best would be monthly) into the respective ETF. That's it - completely hassle-free.
- Index family FTSE All-World - covers about 90% of the investible market for large and mid cap stocks from the FTSE Global Equity Index - represented by 3,722 constituents
  ETF: Vanguard FTSE All-World (ISIN: IE00B3RBWM25 - quarterly distributions paid) - with TER of only 0.22% p.a.
- Index family MSCI ACWI (All Country World Index) - covers about 85% of investible market represented by 2,893 constituents
  ETF: iShares MSCI ACWI UCITS ETF (ISIN: IE00B6R52259 - accumulating) - with TER of only 0.2% p.a.

2. The Doable - two ETFs, one equity ETF combined with one bond ETF, target allocation according to individual risk appetite (e.g., equity/bond ratio of 60/40 or 70/30) considering a saving rate of 100 EUR, 60 EUR would go into the equity and 40 EUR into the bond ETF.

Equity ETF: Choose one from the above described option, to be globally diversified
Bond ETF: Either a pure government bond ETF (e.g., Vanguard USD Treasury Bonds or European government bonds) or a mix of international corporate and government bond, trying to blend higher yield of corporate bonds with less volatile government bonds.

Once per year, the target weighting of both ETF is reviewed by the investor and adjusted if deviation is significant (rebalancing).

3. The Autopilot-Portfolio - for each world-region one equity ETF separately in order to reduce the heavy weight of North America in the MSCI ACWI or Vanguard All-World. Each of the world region is being weighted according to ratio of their world income ratio.
Since most of the broader equity indices do not contain small caps, on top such ETF could be added. For portfolios with more than 2-3 ETFs it would make sense to hand over to an automated robot. Here, once target allocation ratios per ETF are being defined and for a reasonable fee rebalanced in the chosen time interval (e.g. yearly). Such autopilot-portfolios can be run starting with a total monthly saving rate of 50 EUR which will be invested automatically at the pre-defined weighting.

Depending on your personal preference and willingness to spend time on investing, choose one from the above suggested ideas and adjust to your personal risk appetite and needs.

Why to replicate the global economy by five or six ETFs if it is so convenient to put your money only into one ETF? In case, you do not feel comfortable to invest 50-60% of your money into North America - the world largest capital market - then split the world into major regions and adjust weighting as follows, for example:

North America (38%)
Europe (including the UK) (20%)
Emerging Markets (20%)
Japan (7%)
Asia Pacific ex Japan (5%)
Global Small Caps (10%)

Finally, you have composed your desired globally diversified ETF portfolio, now it is time to look for a broker which provides the right services at the lowest possible cost. Follow Smart Money Diary's 3rd step in order to find the best broker for your needs.

Step 3