The easiest way to diversify your portfolio

The single most important factor for your portfolio performance is getting asset allocation right.

And now ETFs (I'll explain all about these in a minute) offer an amazing way to achieve this. We private investors have never had the opportunity to balance our portfolios in such an effective way as we can today.

Asset classes like emerging markets, bonds, or commodities are often overlooked and mean that you may miss out on opportunities for profit and to reduce risk. It's time to tackle areas of our portfolios lacking balance.

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ETFs really do open up a whole new world for savings and retirement planning. The number of funds is constantly expanding, offering you the chance to diversify your portfolio like never before

The great idea behind ETFs

The idea with an Exchange Traded Fund (ETF) is that the price moves in tandem with an index. So a FTSE 100 ETF will move in line with yes, you've guessed it, the FTSE 100 index. What's more, you'll also get the dividend on the FTSE (just over 3% right now), either paid out in cash, or rolled-up in the fund.

With ETF investing, we're really saying that we don't expect to be able to beat an index. Its saying, that most professional fund managers don't beat the index, so why should we even try.

We don't want to pay exorbitant fees to fund managers who regularly disappoint. We would rather pay tiny management fees (usually around 0.5% per annum) and try to outperform by choosing the right asset classes to invest in.

Asset allocation has proven itself to be much more important when it comes to fund performance than stock picking. What's more, this approach allows us to build portfolios much more in line with our individual needs.

One alert reader noticed a momentary lapse on my part in Wednesday's communique. I said that you pay stamp duty on ETFs, but in fact, ETFs are generally exempt from stamp duty. So there's another great reason to use this wonderful investment tool to build better and more robust portfolio.

Some portfolio ideas using ETFs

Let's consider some portfolios. A portfolio is made up of different asset classes like UK shares, bonds, commodities etc. To make the most out of your investments, it's paramount that you consider your asset allocation (how much cash you put into each class) very carefully.

It's important to think about your circumstances and what you're saving for. All of the asset allocations that I'm going to suggest can be set up through your normal stock broker. What's more they shouldn't take more than about ten minutes to put together. (All the codes etc you need to trade follow at the end of this article). We're looking at long-term saving portfolios here. Once you've seen how it all works, you can put together your own asset allocations to suit your specific needs. Here's a pretty simple, yet classic asset allocation.

You can get exposure to each of these asset classes simply by buying one ETF through your broker. This portfolio is weighted towards equities, that is, for capital growth. There's also some property, gilts and commodities to provide diversification.

Now, within the sectors, the ETFs are fully diversified. For instance, the UK gilt fund will follow a broad index of treasury gilts, in the same way that the FTSE 100 will follow the index of the UK's largest listed 100 companies. The great thing about these funds is that you don't have to worry about stock picking. It's agreed at the outset that we are happy to get the return of the index being tracked.

Our aim is to make the most of asset allocation to bring about decent returns with the least risk possible. We diversify risk in two ways: as mentioned the index is already fully diversified in itself; and we can build the portfolio to our specific needs. Let's look at an example

Let's say you are using this savings scheme for retirement. But you don't want to retire in the UK, but maybe Tuscany. In this case, it would make more sense to weight your portfolio towards European equities, rather than UK equities. Because you want euro income for your retirement, we can get rid of currency risk by buying European instead of UK equities. We can even put some of our cash savings into a European ETF account.

So, just by juggling around the figures a bit, you can alter the risk profile of the fund to suit your needs. In a different scenario, you may be considering selling a large family home to help fund retirement, in this case it may be better to reduce the property weighting and rebalance the portfolio elsewhere.

The examples we've seen so far are quite basic. The great thing with ETF portfolios is that you can make them as simple or as complex as you like. Let's have a look at introducing a few more ideas into our portfolio:

Now, all we've done here is to keep the same sector weightings, but broken them down a bit further. So for UK equities, we've introduced the FTSE 250 and the FTSE all share too.

Does this provide a benefit? Well it is certainly more diversified. The FTSE 250 and all-share are more focused on the UK, than the FTSE 100 (which really represents global industry, though it's listed in the UK). If you're worried about UK sovereign debt, you can introduce Euro sovereign debt too as I've done in this example.

Your savings need you!

It's very easy to hand responsibility for your finances to an IFA, or just carry on with the savings vehicles you've always had. Most of us (me included) can be a bit lazy when it comes to taking control of our finances. Now is not a time for laziness. Now is the time to grasp the nettle.

A great idea is to review your portfolio every three months or so. Take a while to think carefully about asset allocation dedicated to your circumstances. Do you really think an IFA is going to get this intimately involved with your needs? I'm not so sure. If you'd like to put your own portfolio together using some of the ideas I've mentioned, then here are all of the stock codes and details you'll need when dealing with your stock broker.