A lot of investors and investment managers talk about diversification and diversified portfolios, but if you are new to investing you may be wondering: just what is a diversified portfolio and how to I build one?
Put simply, a diversified portfolio is a collection of investment securities that perform differently and will, on average, provide higher returns with lower risk than the individual securities within the portfolio.
Having a diversified portfolio is a necessary for investors to reduce risk and increase the probability of achieving expected returns. And the good news is that anyone can learn to build a diversified portfolio.
Why diversification works
The purpose of a diversified portfolio is to reduce the risk that the overall portfolio will lose value while still providing good returns.
Does it work?
Yes! … if done correctly
Diversification works because combining investments whose returns are not correlated reduces the chances that losses will be as large as they might have been if you had only invested in a few investments. Holding many different investments reduces the overall investment risk.
Let’s look at a real example. If you had invested your entire portfolio in Bank of America stock (BAC) in 2006, your investment would have lost 91% during the financial crisis of 2008. However, if you added a second stock, Ford (F), to your portfolio, you would have lost a little bit less, only 84%. The more investments you add (as long as they are not correlated), the more risk is reduced. If instead of buying BAC and F you had purchased an S&P 500 index fund (such as SPY) that holds 500 stocks, your loss would have only been 50%.
|Portfolio #1 – 100% BAC stock||Portfolio #2 – 50% BAC stock, 50% F stock||Portfolio #3 – S&P 500 index ETF (e.g., SPY)|
|Number of stocks held||1||2||500|
|Return (CAGR, 2006-2019)||-1.7%||1.5%||8.2%|
|Standard deviation of returns||45%||43%||14%|
|Max drawdown / loss||91%||84%||50%|
Measures of diversification
Standard deviation – Standard deviation is a measure of the variation of returns. The higher the standard deviation, the higher variation of historical returns, which is generally associated with higher risk. Lower standard deviation means the returns are more consistent. A relatively lower standard deviation indicates more diversification.
Sharpe ratio – The Sharpe ratio is a measure of risk-adjusted return. This means it measures the amount of return for the amount of risk. A higher Shape ratio is better than a lower one.
So which investments make good diversified portfolios?
Tenets of well diversified portfolios
Portfolios with many investments
As we saw in the example above, adding more stocks decreased the risk of drawdown and variability of returns for the portfolio. Studies have been done, but there is no hard and fast rule as to how many investments are needed. The answer is many. If you’re picking individual stocks you will need hundreds to thousands of stocks for proper diversification. If you’re purchasing ETFs or mutual funds it will be easy to hold hundreds or thousands of different types of investments in a single investment.
Non or inversely correlated investments
Diversification will only reduce risk if the investments are not correlated. An investment is correlated with another asset if it increases in value with the other asset. If an investment loses value when the other investment increases in value, then they are inversely correlated or not correlated. Correlation is measured on a scale of -1.0 to 1.0, where 1.0 is correlated, and -1.0 is inversely correlated.
Investments in different industries
Companies within the same industry often perform very similarly over time, especially in cyclical industries. This means that their stock returns will be highly correlated. Investing in a variety of industries will reduce the risk of larger drawdowns due to correlated investments.
Investments in different asset classes
Stocks / equities are great investments but adding other asset classes to your portfolio can really help with diversification. It’s really hard to build a well diversified portfolio with stocks alone because many stocks are at least slightly correlated. Bonds and real assets (cash, TIPS, T-bills, real estate, commodities) can be much less correlated with stocks–providing fantastic diversification.
Investments in different geographies
Just like industries, overall stock (and bond) markets within certain regions can also be correlated. Many U.S. investors invest most or all of their portfolio in U.S. stocks and bonds. This is called home country bias and it can be dangerous. It’s a good idea to invest in global investments with lower correlations to each other rather than concentrating your investments in any single county.A well diversified portfolio consists of a variety of non-correlated assets of different classes, across different industries and geographies Click To Tweet
Building a diversified portfolios
Anyone can learn to build a well diversified portfolio and it doesn’t have to be complicated either. A well diversified portfolio could be as simple as buying 2-4 ETFs (which can hold hundreds or thousands of investments).
One good starting point is beginning with one of the many popular portfolios. You can evaluate them for yourself, even make your own changes or additions. I like to use the Portfolio Visualizer to backtest portfolios. Using Portfolio Visualizer, you can test how portfolios would have performed historically and assess portfolios with measures such as higher Sharpe ratios, lower drawdowns, and higher returns. It’s important to note here that historical results are no guarantee of future results.
Popular diversified portfolios
There are many popular portfolios that you could begin with and here are a few examples.
60 / 40 portfolio
This simple portfolio is 60% stocks and 40% bonds. This portfolio can be implemented by simply buying two ETFs. The stocks portion could be U.S. stocks (such as a single S&P 500 index fund) or a total stock market fund (which includes non-U.S. stocks). Likewise the bond fund could be a total bond ETF.
David Swenson Yale Endowment
This is a portfolio made popular by David Swenson who managed Yale University’s endowment investments. It is invested as follows and can be implemented with 6 ETFs:
- U.S. stocks – 30%
- International stocks (developed markets) – 15%
- International stocks (emerging markets) – 5%
- Bonds – Long-term treasuries – 15%
- TIPS – 15%
- Real estate – 20%
Warren Buffett portfolio
In a letter to Berkshire Hathaway shareholders, Warren Buffett once said that his will instructs that the money left to his wife be invested 90% in a stock index fund and 10% in short-term government bonds.
Build your own
If you don’t like any of the above portfolios, you can also develop your own. Recall the tenants I mentioned earlier: diversified portfolios should have many different non-correlated investments across different industries, a variety of asset classes, and a global perspective.
Start with a mix of stocks, bonds, and real assets and balance expected returns with your risk tolerance by backtesting different proportions. Remember that markets can be volatile and historical returns do not guarantee future results. However, investing in a well diversified portfolio does increase the probability that you will achieve your expected return with less risk than a less diversified portfolio.
Additionally robo advisors and traditional advisors can build diversified portfolios for you if you’d like to go that route.
Regardless of how you get there, diversification is important to reduce investment risk and increase the probability of achieving expected returns. How do you diversify your investment portfolio?