How to Build a Truly Diversified Portfolio
If there’s any concept that effectively gospel in financial circles, it’s that diversification is the key to a healthy portfolio.
Diversification is an investment strategy wherein you spread your portfolio holdings across various types of assets throughout different sectors, and even in different countries. The idea can be summed up with the age-old adage, “Don’t put all your eggs in one basket.”
Cliches are cliches for a reason, and a diverse portfolio of different assets has been shown time and again, in good markets and in bad, to not only provide the most sustainable upside but also protect investors from excessive downside risk.
In a growing economy, certain assets (like stocks and other equities) usually have higher returns than others. But these assets also tend to be riskier and are generally hit harder than other asset classes during bad economic conditions.
Meanwhile, being invested in sectors and asset classes that are less susceptible to market volatility could protect you against the downside during market downturns.
Why Diversification is Important
While it’s true that asset classes, as a rule, are more highly correlated than they’ve historically been, even in today’s highly efficient market environment, diversification can still reduce your portfolio’s overall risk.
Even during the 2008–2009 financial crisis, diversification was proven to help investors reduce their overall losses. A portfolio consisting completely of stocks would have lost about 48% from January 2008 to February 2009 (which is when the bear market bottomed), whereas a diversified portfolio (70% stocks, 25% bonds, and 5% short-term investments) would have only lost 35% over the same time frame. And, while the former portfolio would have seen gains of about 162% during the main years of economic recovery following the financial crisis (March 2009 to February 2014), the diversified portfolio still would have seen nearly 100% gains over the same period.
And from January 2008 to February 2014, returns on the two portfolios would have been mostly comparable, with the all-stock portfolio at 31.8% and the diversified portfolio at 29.9%.
The long and the short of it is that diversification helps investors eliminate downside risk during an unhealthy market while maintaining exposure to economic growth during a healthy market.
How to Diversify your Portfolio
The key to diversification is to be invested in assets that are not highly correlated—that is, the movements of one have little (or an inverse) impact on the other.
For instance, the movement of domestic stocks have generally had the opposite effect on the price of bonds for more than a century. As such, owning both would theoretically protect you from downside risks, because they perform (well or poorly) opposite of one another.
As with any investment strategy, what diversification looks like for you will depend on your specific investment goals, risk tolerance, and time horizon (that is, how long you plan to remain invested before you need to start taking profits). It’s important to consider all of these factors when building a diversified portfolio:
- How much do you need to gain from each investment?
- How long do you plan to be in each investment?
- What major expenses are you saving for (retirement, education expenses, etc.)?
- How aggressive do you want to be?
- Is your investment strategy more hands-on or hands-off?
- What is your risk tolerance?
- How do you react to headline news?
- Do you tend to sell on fear or are you comfortable waiting out volatility?
As an example, a conservative—but more hands-on—portfolio might be diversified this way:
- 50% bonds (a mixture of government and high yield)
30% short-term investments
15% domestic stocks (a mixture of market cap sizes across various sectors)
5% foreign stocks
The best return over a one-year timeframe for portfolio diversified in this manner between 1926 and 2008 was about 31%. The worst return over the same period was about -18%.
A more aggressive portfolio—but one that required less short-term oversight—might look like this:
- 60% domestic stocks
- 25% foreign stocks
- 15% bonds
While the best return over the same time frame as the above example was substantially higher, at about 136%, the worst return was near -41%.
Neither of these example portfolios is inherently better or worse than the other. It depends on the individual investor to decide what is right for him or herself.
Diversifying Beyond Asset Classes
While many investors understand the concept of diversification, many are not nearly as diversified in practice as they believe themselves to be.
Because a mixture of stocks, bonds and cash is one thing, but what if all of those assets are based in the U.S. and the U.S. economy collapses? Or, what if bond yields start to mimic stock action due to the widespread adoption of similar portfolio strategies? The fact is, true diversification requires a little more thought.
If that sounds overly ambitious for you, one of the simplest and safest ways to build a diversified portfolio is to invest in funds that hold a basket of various assets. Investing in various types of funds (a mixture of mutual, exchange-traded, index, and government bond funds, for example) can immediately build up your portfolio’s diversification.
Whatever the case, no portfolio is static. Your level of diversification will vary depending on how your portfolio performs. If, for instance, you’re invested in both Blue Chips and Big Pharma stocks, and the former is performing better than the latter, your portfolio is eventually going to become more heavily weighted toward the former over time. That’s why rebalancing is an important component of any diversified portfolio.
It’s also important not to keep your portfolio on “auto-pilot.” Keep an eye on all your investments, and follow your strategy about when to buy and sell.
Finally, investment goals change. The strategy you developed years ago may no longer suit your current needs. So make sure to be constantly evaluating your overall plan, and make sure to adjust it as needed.