Portfolio Management

How to Diversify Your Investment Portfolio

How to Diversify Your Investment Portfolio
By
Savvy
|
January 12, 2024

Diversifying your investments is one of the best ways to help reduce risk and improve returns over time. By spreading your money across different asset classes, sectors, regions, and risk profiles, you avoid overexposure to any single investment. This allows parts of your portfolio to remain stable or even grow when other parts decline.

This comprehensive guide provides actionable tips to help you build and manage a properly diversified portfolio tailored to your financial situation.

Conduct Thorough Market Research

Before deciding how to allocate your assets, spend time researching the various investment options available1. Gain an in-depth understanding of the historical risk and return profiles of stocks, bonds, real estate, alternatives like private equity and commodities, and cash equivalents.

Additionally, analyze economic trends and projections to determine which sectors, industries, companies, and geographic regions are poised for growth versus decline1. This will allow you to tilt your asset allocation towards areas with strong upside potential.

For example, technology and healthcare stocks have outperformed the broader market over the past decade. However, energy and utility stocks often do well when interest rates are rising. Keep abreast of macroeconomic developments as well as micro trends impacting individual investments.

Allocate Across Multiple Asset Classes

Experts recommend holding at least 3-4 major asset classes to achieve adequate diversification2. This includes domestic and international stocks, investment-grade and high-yield bonds, real estate, and alternative investments.

The appropriate allocation depends on your risk tolerance, time horizon, income needs, and overall financial goals3. Conservative investors may allocate 50% or more to fixed income, while aggressive investors might hold over 70% in equities. On average, stocks account for 50-60% of a diversified portfolio3.

Here is a sample asset allocation for a moderate risk tolerance:

  • Stocks: 60%U.S. Large-Cap Stocks: 35%
  • Bonds: 35%U.S. Investment-Grade Bonds: 25%
  • Real Estate: 5%

Diversify Within Each Asset Class

In addition to diversifying across major asset classes, you should also diversify within each class4. For stocks, this means owning shares in companies across various sectors, industries, market capitalizations, growth rates, valuation levels, and geographic regions.

For example, you may invest in technology stocks with high growth as well as consumer staples stocks with slower but steady growth. You can further diversify into small-cap value stocks and large-cap growth stocks.

Similarly for bonds, you should own issues across the maturity spectrum from short-term to long-term and across the credit quality range from investment-grade corporate bonds to high-yield junk bonds4. Taking this approach minimizes concentration risk.

Consider Alternative Investments

Once your portfolio covers the core asset classes, alternative investments like private equity, hedge funds, managed futures, commodities, and precious metals can provide additional diversification5. Since these assets have minimal correlation to traditional investments, they can enhance returns while lowering volatility.

Ultra high net worth investors allocate over 50% of their assets to alternatives given the diversification benefits6. However, alternatives come with much higher fees, lower liquidity, and complexity around due diligence and access. For accredited investors with at least $1 million in net worth, a 10-20% allocation to alternatives is recommended.

Rebalance Your Portfolio

As market conditions change over time, your portfolio asset allocation will drift out of balance7. For example, if U.S. stocks significantly outperform international stocks in a given year, your domestic allocation may jump from a target of 50% to 65%. This leaves you with overconcentration risk.

Revisit your portfolio at least annually to sell assets that now represent an overweight allocation and buy assets that are underweight7. This helps to force you to buy low and sell high while restoring balance. It also helps you lock in some gains from top performers before they hit a peak.

Utilize Low-Cost Diversified Funds

Studies show that a diversified portfolio of 25-30 individual stocks eliminates most unsystematic risk12. However, constructing such a portfolio requires substantial research and monitoring efforts from individual investors.

Instead, you can invest in low-cost, diversified mutual funds and ETFs that provide instant diversification. Index funds and target date retirement funds offer diversification across hundreds of stocks and bonds in a single ticker8. Robo-advisors provide automated portfolio management services including periodic rebalancing.

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Sample Diversified Portfolio

Here is an example of a diversified portfolio for an aggressive investor with a high risk tolerance8:

Stocks: 80%

  • U.S. Large Cap Stocks: 25%Vanguard S&P 500 ETF (VOO)
  • U.S. Mid/Small Cap Stocks: 15%iShares Russell 2000 ETF (IWM)
  • International Developed Stocks: 25%Vanguard FTSE Developed Markets ETF (VEA)
  • Emerging Market Stocks: 15%iShares MSCI Emerging Markets ETF (EEM)

Bonds: 15%

  • Investment Grade Corporate Bonds: 10%iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
  • High Yield Corporate Bonds: 5%SPDR Bloomberg High Yield Bond ETF (JNK)

Alternatives: 5%

  • GoldiShares Gold Trust (IAU)

This sample portfolio provides broad diversification across major equity classes along with fixed income and an alternative asset. The total expense ratio for these ETFs ranges from 0.03% to 0.15%, ensuring low frictional costs.

Maintain Proper Diversification

Diversifying your investments takes time but will pay off  over your lifetime by helping to reduce portfolio volatility while improving risk-adjusted returns. As legendary investor Benjamin Graham said, “Diversification is the only free lunch in investing."

Stick to the strategic asset allocation plan you develop based on thorough research rather than emotion. Avoid the temptation to overload into “hot” investments when they are rising or panic sell assets when they are declining.

Also, rebalance your portfolio at least once a year back to target allocations and re-evaluate your plan if life circumstances or risk tolerance changes substantially9. Feel free to contact me if you need help constructing and managing a diversified portfolio tailored to your financial situation.

Disclosure:Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives.Incorporating alternative investments into a portfolio presents the opportunity for significant losses including in some cases, losses which exceed the principal amount invested. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors. Asset allocation and diversification strategies do not ensure profit or protect against loss in declining markets.

References

  1. "Investment Diversification: What It Is and How To Do It." NerdWallet, 2022, https://www.nerdwallet.com/article/investing/diversification.
  2. "Portfolio Diversification: Why It's Important." Bankrate, 2023, https://www.bankrate.com/investing/diversification-is-important-in-investing/.
  3. "5 Tips for a Diversified Investment Portfolio." New York Life, 2023, https://www.newyorklife.com/articles/strategies-to-diversify-investments.
  4. Lamb, Joshua Kennon and Brian Perry. "How To Diversify Your Investment Portfolio (w/ Examples)." I Will Teach You To Be Rich, 2023, https://www.iwillteachyoutoberich.com/diversified-portfolio-examples/.
  5. "Guide to diversification." Fidelity Investments, 2023, https://www.fidelity.com/viewpoints/investing-ideas/guide-to-diversification.
  6. Shah, Hersh and Aashika Jain. "Beginner’s Guide: 12 Tips For Diversifying Your Investments." Forbes, 2021, https://www.forbes.com/advisor/in/investing/beginners-guide-12-tips-for-diversifying-your-investments/.
  7. "The Advantages of Diversification." Charles Schwab, 2023, https://www.schwabmoneywise.com/essentials/the-advantages-of-diversification.
  8. Wall Street Zen. "7 Diversified Stock Portfolio Examples For Beginners." 2023, https://www.wallstreetzen.com/blog/example-stock-portfolios/.
  9. "6 Ways To Diversify Your Investing Portfolio." Bankrate, 2023, https://www.bankrate.com/investing/tips-for-diversifying-your-portfolio/.
  10. "How to Cite Sources." HubSpot, 2023, https://blog.hubspot.com/blog/tabid/6307/bid/33098/how-not-to-steal-people-s-content-on-the-web.aspx.
  11. The Correct Way to Cite Sources / Repost Content." Commit Agency, 2020, https://commitagency.com/blog/the-correct-way-to-cite-sources/.
  12. "What Is Diversification?" Investopedia, 2023, https://www.investopedia.com/terms/d/diversification.asp.

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