- Diversification in an investment portfolio helps reduce risk and improve efficiency.
- You can build a diversified portfolio by establishing a strategic asset allocation and diversifying within the designated asset classes.
- The most diversified portfolios contain some combination of the following asset classes: stocks, bonds, alternative investments and cash equivalents. Some portfolios also include annuities.
How To Build A Diversified Portfolio
Diversification is the process of mitigating risk by spreading exposure over many dissimilar items. Informally, it is described as “not putting all your eggs in one basket” — an adage that underscores the sensibility of avoiding highly concentrated positions.
In terms of investing, diversification entails maintaining a portfolio of distinct asset classes in order to reduce volatility and improve efficiency, or the return per unit of risk.
The appropriate proportions of the various asset classes, which include annuities, stocks, bonds, alternative investments and cash, can vary from one investor to the next depending on investment objectives and tolerance for risk.
Building a diversified portfolio is a straightforward process, but it requires foundational knowledge about investing. If you are a novice investor, you should consult with a fiduciary financial advisor to optimize your portfolio.
If you’re just looking for some perspective, consider the following two-step process to build a diversified portfolio.
Diversification is great for asset allocation among asset classes. But it’s also important in terms of asset location, or what type of accounts your money is in invested: traditional retirement accounts, ROTHs, non-qualified brokerage accounts, annuities (qualified and non-qualified), etc. Having a good mix of account types can help diversify away other types of risks, like liquidity risk, or changes in tax law.
Step 1: Establish Your Strategic Asset Allocation
The first step to building a diversified portfolio is to establish a strategic asset allocation. It should be reflective of your investment objectives — ensuring liquidity, preserving capital, generating income and fueling growth — as well as tolerance for risk, which depends largely on your investing time horizon.
Your strategic asset allocation specifies the proportions of the various asset classes you should hold to achieve your desired investment outcomes. Most people settle on some combination of the following asset classes, which exhibit relatively low levels of correlation with each other.
- Growth-oriented securities that offer investors share-based ownership in publicly traded companies. Over long periods of time, stocks have outperformed other asset classes, but they have also been comparatively volatile.
- Fixed-rate debt securities that generate predictable streams of income and serve as a stabilizing force in a portfolio. This is most true for investment grade bonds; noninvestment grade bonds expose investors to elevated levels of credit risk and price volatility.
- Alternative Investments
- A broad category of assets that exhibit varying levels of risk and return. They can be a nice complement to stocks and bonds, and they can allow investors to emphasize key investment objectives. Common alternative investments include real estate, commodities and high-yield bank loans.
- Cash Equivalents
- Highly liquid but relatively low-yielding, short-term instruments that provide investors a safe place to store money. They include high-yield savings accounts, certificates of deposit (CDs), U.S. Treasury bills and money market funds.
Types of Asset Classes
Many investors opt to incorporate annuities into their investment portfolios as well. Many variable annuities serve the same purpose as stocks, while fixed or indexed annuities are comparable to bonds.
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Step 2: Consider Your Consumption Goals
As noted previously, an appropriate asset allocation strategy is reflective of your investment objectives and tolerance for risk. Unfortunately, getting your arms around these multifaceted variables can be difficult, even with the help of a reputable financial advisor.
The most robust investment plans address this challenge by incorporating an intuitive, quantitative approach — otherwise known as the consumption-focused approach.
The consumption-focused approach entails determining how much money you require to get to retirement and how much you require to live throughout your nonworking retirement years.
To apply the consumption-focused approach, you need:
- Visibility into your current income and expenses.
- Macroeconomic projections for the near and long term.
- An estimate of anticipated sources of supplemental retirement income (pension income, Social Security benefits, etc.).
- An indication of the way you plan to live in the future.
Ultimately, the purpose of establishing a strategic asset allocation is to position yourself for financial success. Generally, the best outcomes are achieved when a wealth of qualitative and quantitative inputs are incorporated into the process.
Step 3: Diversify Within Asset Classes
After establishing your asset allocation, the next step in the diversification process is to determine which securities to own within each asset class in your strategic framework. In the past, investors had to do this on their own, handpicking individual securities and buying and selling them to maintain their desired exposures.
Today, there are a myriad of low-cost, fund-style vehicles that offer immediate diversification benefit for stocks, bonds, alternative investments and cash equivalents. The most economical vehicles are passive in nature and come in the form of index funds and exchange-traded funds (ETFs).
There are also many diversified, actively managed mutual funds, which offer investors the potential for higher-than-average returns. Unfortunately, most of these vehicles have high fees and lackluster track records.
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Step 4: Consider All Possibilities
When it comes to diversifying within an asset class, it’s usually beneficial to spread positions across sectors, industries and geographic regions (developed markets and emerging markets). The goal is to reduce the impact of poor performance in any one investment — or group of similar investments — by having others that may perform well.
Regarding publicly traded stock and bond asset classes, enhanced diversification can be achieved by mixing size and style themes internationally. This means ensuring a mix of large-cap, small-cap and mid-cap companies across the value versus growth spectrum.
Other Frequently Asked Questions About Diversification
Correlation is a statistical measure of the extent to which two assets exhibit similar return patterns. Positive correlation means the assets’ returns tend to move in the same direction; negative correlation means they tend to move in the opposite direction. Relatively low positive correlation or negative correlation is beneficial from a diversification standpoint.
Historical analyses have shown asset allocations accounts for over 90% of the average portfolio’s returns and volatility, making it the most critical aspect of any sophisticated investment plan.
Diversification cannot eliminate all risk. It can eliminate unsystematic risk, which is risk associated with specific investments and investment positions. It cannot eliminate systematic risk, which is the risk associated with the broader market.
Theoretically, diversification makes sense for all investors. However, the degree of diversification can vary depending on an investor’s investment objectives and tolerance for risk. A highly risk-averse investor may own nothing but bonds and cash, while a risk-tolerant individual may maintain a small cash reserve and put everything else in stocks. Someone with a risk tolerance in between may have a balanced mix of bonds, stocks and alternative investments, along with a comfortable cash reserve.