How to use ETFs to build your share portfolio

2015-01-29 20:16

There are many reasons why one should never put all their eggs in one basket. In our day-to-day lives examples of this are plentiful.

Hopeful matriculants often apply to multiple universities to increase their chance of acceptance from of least one of them. These students will eventually apply for multiple jobs upon graduation again to increase their chance of job-finding success. Even major companies produce a multitude of goods and products for customers – simply to ensure that not all their profitability hopes are pinned on a single product.

The idea thus in not putting all your eggs in a single basket is based on a strategy to ensure a successful outcome either when at a crossroads or when presented with options. The thinking is sound as it’s based on the fact that there is safety in numbers; or at least one of the options will pay off.

Building a well-constructed investment portfolio is no different. Take a trader who buys and sells shares – he does so in the hope of making money. However, if he gets ahead of himself and over-concentrates his investment on a single bad bet, he could lose a lot of money.

A much better balanced strategy, not to mention far less emotionally draining for him, would be to approach investing the way he would other aspects of his life. Spread his risk – a common technique in doing so for investment purposes is what is called the core satellite approach to investing.

This heavenly sounding strategy involves building your portfolio in a way that is analogous to the manner in which satellites revolve around the earth. The thinking here is that the core of the portfolio should be invested in a low-cost, low-risk and well diversified portfolio like an Exchange Traded Fund (ETF) – much the same way as the larger earth, this should form the core of your portfolio.

The satellite in this analogy can then be made up of single shares which the investor feels might appreciate in value – the size of the satellite trades should obviously be a lot smaller than the core. This combination of low-cost/efficient ETF core and high conviction individual share, trades as satellites and results in a well balanced share trading portfolio that has both defensive and growth qualities.

The above core satellite approach to investing can also be used by the average unit trust investor to build an equity unit trust portfolio. For example a low-cost equity ETF tracking the overall market can once again anchor his portfolio at the core with actively managed equity units trusts used as satellites. Thus this deliberate spread of risks and spread of both defensive and growth qualities in his approach makes for sound holistic portfolio construction. The key point, however, is that making good long-term investment decisions is no different from making good common sense everyday choices.

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