Investment legend Warren Buffett included investment guidelines in his will for his wife, recommending 10% of cash be allocated to short-term government bonds and 90% to a low-cost S&P 500 index fund. While this approach may seem unexpected given his reputation as an investor, the reasoning is practical: many individuals lack expertise in selecting specific equities, so investing through an index is a straightforward alternative.
A common method for index investing is via exchange traded funds (ETFs). Index ETFs aim to replicate the composition of their underlying indices as closely as possible. These products appeal to passive investors—those who invest with minimal ongoing management and periodically rebalance their portfolios.
Using asset class diversification, it is feasible to construct a diversified portfolio with just two ETFs for an equity-bond mix, or up to four or five for broader diversification strategies such as the Bedokian Portfolio. However, the extent of diversification depends on several factors.
Selecting global equity and bond ETFs, along with additional options like global real estate investment trust (REIT) ETFs and commodities ETFs, can provide broad market exposure. However, true diversification may be limited by the weighting methods of the indices and the corresponding ETFs. Market-capitalisation weighting assigns proportionally higher representation to larger companies, while equal weighting treats all constituent securities equally. Market-cap weighted ETFs are more prevalent, which means that sectors and countries with larger companies, such as U.S. technology firms, tend to dominate these indices, potentially reducing diversification.
To achieve better diversification, additional ETFs targeting specific regions, countries, or industries may be required to manage concentration risk. As a result, investors might select multiple ETFs for each asset class rather than relying on a single fund. Further considerations, such as bond duration and property types within REITs, also affect diversification.
Passive ETF investing remains one of the most straightforward approaches compared to other investment styles. While complete diversification across all levels is challenging, selecting appropriate ETFs for each asset class can provide reasonable market coverage with some compromise regarding regional or sectoral biases. The primary goal of investing is to benefit from compounding returns that outpace bank savings rates and inflation.
Disclosure
The Bedokian is vested in the S&P500 via the SPY ETF.
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