If You Own Just 4 ETFs for the Rest of Your Life, History Says This Is the Best Combination

Proper portfolio construction really isn't as hard as many people think it is. You don't need 10-15 different ETFs to be diversified. You don't want to invest in a bunch of funds that have a high overlap with each other. You honestly just need a few funds that cover different areas of the market, are able to work together to mitigate overall risk, and come with very low expense ratios.

In today's market, it's tougher because 1) the S&P 500 is very top-heavy with a handful of mega-cap tech names and 2) most of the best-performing ETFs may have different names but their portfolios look substantially the same.

Here's an example that probably sounds familiar to some people. You own a portfolio that includes the Vanguard S&P 500 ETF (NYSEMKT: VOO), the Vanguard Information Technology ETF, the Invesco QQQ ETF, the Vanguard Growth ETF, and the VanEck Semiconductor ETF.

You think you're diversified because you own several different ETFs. But it turns out the top 10 holdings across all of them look substantially the same. You need different ETFs with different objectives and different target markets to be truly diversified. You won't hold the best performers all the time. But you'll have a portfolio that works well together, reduces some overall portfolio risk, and is built for long-term wealth creation.

If I were to build a portfolio from scratch today, I'd make sure it included four asset classes: U.S. large-cap stocks, U.S. small-cap stocks, international stocks, and fixed income. I understand these won't all be popular choices. But market leadership can change quickly and for years at a time. This combination helps balance out the highs and lows and likely keeps you participating with the leaders at all times.

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Here are the four ETFs I'd use based on history, exposure, and performance:

Vanguard S&P 500 ETF

For U.S. large-cap exposure, there's no real point in overthinking it. The Vanguard S&P 500 ETF invests in hundreds of the U.S. economy's largest companies and charges investors next to nothing to own it. That sounds like a core portfolio holding if there ever was one. And this rather vanilla exposure has produced some of the stock market's best returns over the past decade, returning an average of 15% per year.

Avantis U.S. Small Cap Value ETF

I'm using the Avantis U.S. Small Cap Value ETF (NYSEMKT: AVUV) not so much as a play on small-cap value stocks as on small-cap quality stocks. This fund specifically targets companies with high profitability ratios. That's important because many stocks in this category are cheap for a reason -- they're in financial trouble, and nobody wants to own them. By targeting profitable companies in this group, you achieve a balance of quality and value that has historically delivered above-average returns.

Vanguard Total International Stock ETF

Investors have been underinvested in overseas equities for years. It's understandable why. They haven't had an extended stretch of outperformance since the late 2000s. But historically, leadership between U.S. and international stocks has gone back and forth in multi-year cycles. And international is long overdue for another run. The Vanguard Total International Stock ETF (NASDAQ: VXUS) provides the broadest exposure to both developed and emerging markets, avoiding the risk of picking which markets will do best.

Vanguard Total Bond Market ETF

The Vanguard Total Bond Market ETF (NASDAQ: BND) will probably be an even less popular choice than international stocks. Long-term bond yields are at around two-decade highs. Inflation and debt risks might push them even higher before all is said and done. But bonds still have a reputation as a diversifier for a reason. They often rise in value when stocks fall because investors look for relative safety in uncertain times. The bond bear market has created 4-5% yield opportunities across several investment-grade asset classes, an income component investors shouldn't immediately dismiss.

How to build the 4-ETF portfolio

The Vanguard Total Bond Market ETF should probably be allocated only minimally. For most people with medium- to long-term time horizons, bonds are likely to be a drag on returns, especially given the time to ride out the highs and lows.

The Vanguard S&P 500 ETF would serve as the portfolio's core and might warrant a 50% to 60% allocation overall. The remainder could get split between the Avantis U.S. Small Cap Value ETF and the Vanguard Total International Stock ETF. What's interesting is that both of these funds have done really well over the past year, outperforming the S&P 500 and taking advantage of the market's revival in value stocks.

Historically, these different asset classes have worked well together to achieve a diversified long-term portfolio. When leadership changes, another asset class often takes over to mitigate downside risk. One of the goals of long-term investing should be to smooth out the ride over time. These four ETFs paired together should accomplish that.

David Dierking has positions in Vanguard Information Technology ETF, Vanguard Morningstar Total Stock Market ETF, and Vanguard Total International Stock ETF. The Motley Fool has positions in and recommends Vanguard Morningstar Growth ETF, Vanguard S&P 500 ETF, and Vanguard Total Bond Market ETF. The Motley Fool has a disclosure policy.