How to Build a Diversified Portfolio
Introduction and Overview
Diversification is a key element of successful investing. By diversifying your portfolio, you can help protect yourself from the negative performance of any one investment. This article summarizes a video series created by EP Wealth, exploring diversification in depth – what it is, how to achieve it, and the different benefits it can offer investors.
What Is Diversification?
Diversification is the process of spreading your investment risk across a number of different asset types or investments. The goal of diversification is to build a portfolio that can weather different market conditions and still generate returns. There are two types of diversification:
- Breadth diversification, which is diversifying across different asset types (e.g., stocks, bonds, and cash)
- Depth diversification, which is diversifying within each asset type (e.g., different stocks or different bonds)
Diversification is important because it can help investors:
- Reduce overall portfolio risk: By diversifying, investors can help protect themselves from the negative performance of any one investment.
- Generate returns in different market conditions: A diversified portfolio can perform well in a variety of market conditions, providing investors with the potential to earn returns even when some investments are struggling.
- Meet different investment goals: Diversification can also help investors meet a variety of different investment goals, such as income generation, long-term growth, or capital preservation.
Diversifying a Portfolio in Breadth and Depth
Diversification goes beyond broad asset classes like stocks versus bonds. For example, if a client is more heavily invested in stocks, it’s important to ensure that they’re diversified in large-cap U.S. stocks, small-cap stocks, international stocks, and so on. This is because in the short-term—meaning one year or less—it’s tough to predict how the markets will perform. It’s hard to know which asset classes will become leaders, versus those that will be laggards.
A Risk-Based Investment Diversification Strategy
Even though markets move in cycles, it’s easy to be surprised. A diversified portfolio helps to smooth out the ride. The best way to approach this is by trying to measure the risk of a portfolio based on its expected return. One such measure is standard deviation. When you think back to math class, you may recall standard deviation as that big hump in a bell-shaped curve. As Investopedia defines the term regarding financial matters, it’s a measurement that helps reveal the historical volatility of an investment: “For example, a volatile stock has a high standard deviation, while the deviation of a standard blue-chip stock is rather low.” The role this plays in evaluating a portfolio varies based on what a client is investing in. Let’s say you had a portfolio that’s expected to return 10 percent in a given year, with a standard deviation of 5 percent. That means two-thirds of the time, the portfolio’s actual returns would be expected to fall somewhere in the range of 10 plus or minus five – or between 5 percent and 15 percent. Realistically, the standard deviation for a 10 percent return these days would likely be quite a bit higher. This is how you test a portfolio to determine whether its diversification is expected to deliver the risk characteristics appropriate for a given client.
Asset Allocation Strategies
An Asset Allocation Definition: It Starts With Your Goals
One way to define asset allocation is as a means to an end. That end varies with the specific goals of each individual, including retirement, college savings, or leaving a legacy to heirs or charity. In order to invest your assets in the most tax-efficient way possible, while also providing the growth potential to meet the goals you’ve established, the next step in building a financial plan is to collect information on everything in your life that has a dollar sign. This includes:
- tax returns
- pay stubs
- employee benefits
- investment account statements
- property casualty statements
- estate-planning documents
Advisors plug these details into online software that provides each client with a Personal Financial Website. Advisors then make asset valuations and use cost-basis information to extrapolate the possible outcomes over the next 30, 40, or 50 years and beyond—both for a client’s current portfolio, and to test the possible consequences of revisions to their asset allocation.
Testing Investment Allocations with Simulations
There are various ways to project the future returns of a given asset allocation. While looking at historical average risk and return data for components (such as the S&P 500) is one of the easiest ways, this provides no guarantees and fails to offer insight into the range of possible outcomes. By using a more sophisticated technique, called a Monte Carlo simulation, advisors can gain a greater understanding of the risk of a given portfolio by running it through a thousand different trials that capture the range of possible outcomes, as well as their likelihood. For example, a portfolio that might average a five or six percent annual return could deliver two percent in one year and eight percent in another. Given that variability, advisors need to consider the portfolio’s ability to meet its goals while allowing for the impact of inflation on various aspects of a client’s budget—especially healthcare, which notoriously outpaces general inflation.
Portfolio Allocations Across Different Asset Classes
In order to create a portfolio whose return combines an adequate safety net for budgeted expenses with ongoing growth potential, advisors allocate assets based on the range of returns and risk that simulations project for specific combinations of asset class. This approach goes deeper than the broad classes of stocks as an aggressive component and bonds as a conservative component. Advisors will also be looking at asset subclasses, such as:
- large-cap stocks
- small-cap stocks
- international developed markets
- emerging markets
- high-grade bonds
- low-grade, or junk bonds
It’s important to note that an advisor’s job isn’t done once the initial asset allocation for a client had been determined. Portfolios are dynamic and the economy is constantly changing, meaning different opportunities arise. These opportunities are constantly taken into consideration, and portfolio allocations are changed appropriately based on the current environment.
Asset Location to Minimize Taxes
Asset location, a companion strategy to asset allocation, is a strategy that probably isn’t talked about enough. Asset location refers to which assets you hold in which types of accounts. This is driven by tax consequences. For example, stocks generate dividends and capital gains when sold, both of which are currently taxed at rates that are lower for many taxpayers than those imposed on their ordinary income. Ideally, these assets would be held in taxable accounts. Some mutual funds, on the other hand, may have a lot of annual turnover and routinely generate high capital gains. In such cases, holding them in a qualified, tax-deferred account—say an IRA or 401(k)—can spare the client potentially huge tax bills. There may also be situations, such as with an IRA that is unlikely to be depleted within the lifetime of the owner, where combining the tax-deferred location with a more aggressive allocation to stocks may better deliver the risk/return balance appropriate for the longer-term goals of heirs.
Managing Volatility Through Asset Allocations
Markets rise and markets fall. Volatility can also extend to other aspects of your life, such as employment. When creating an optimally allocated portfolio for a client, one key goal is to offer a smooth ride that reduces volatility sufficiently to enable them to maintain their course. This can mean reducing exposure to high-risk stocks that may appear to offer exceptional straight-line growth, but in reality, look terrible when a Monte Carlo analysis reveals how widely their results may diverge from that expectation. Another risk could be that a given client has too much stock in the company they work for. There should be some diversification between your human capital—where you’re getting your paycheck from—and your financial capital. Above all, the projected return from a chosen asset allocation must be compatible with whatever share of your budget it’s expected to fund. Some people say, “Oh, if the market goes down, I’ll just spend less.” That’s easier said than done. Advisors make sure to build in a budget that’s sustainable for the long term, offering the flexibility you want while enabling clients to withstand the risk projected for the asset allocation that the advisor has chosen to support it.
Types of Risk in Finance
Different Types of Risk
It’s axiomatic in investing that greater returns entail greater risk. And there are multiple types of investment risk. These include:
- Inflation risk, which erodes the value of assets over time
- Market risk, which directly affects asset prices
- Credit risk, which can depress bond valuations while raising yields
- Interest-rate risk, tied to monetary policy, which also impacts bond valuations
The Risk-Return Tradeoff
When asked to explain the relationship between risk and return, an advisor views it in terms of the context of the existing economic environment. For example, given the low-yield environment at present, unless you think inflation is going to be completely absent, you’re not being compensated for holding cash. Therefore, cash carries the risk of decreasing the real value of your dollars as time goes by. This is the intentional result of the Federal Reserve keeping rates low to incentivize buying stocks—a different kind of risk-taking encouraged by the government to inject activity into the economy.
Accepting Higher Risk Has Its Limits
While stocks may offer the potential to outpace inflation, that doesn’t necessarily mean it’s appropriate for someone to have an all-stock portfolio. Granted, bonds—the fixed-income alternative to cash—currently offer yields that are better than cash, but they’re still not great. This leads to a situation sometimes referred to as “TINA”: There Is No Alternative. It’s what drives, for example, a retiree who’s relying on their portfolio for income to go to other, riskier asset classes like stocks, where the dividend yield is higher than what you can get on a lot of bonds.
Managing Risk with Diversification
The reason why you see a lot of diversified portfolios stems from the desire to control the two risks by reaching for additional yield at the margin. You have stocks to give you better odds of generating that real rate of return you need—”real” meaning adjusted for inflation, meaning you have the opportunity for growth. You can offset some of the greater downside risk inherent to stocks by having some of your portfolio in bonds. However, you need to bear in mind that bonds themselves must balance both the risk of inflation and the risk of rising interest rates that can depress their value. Ultimately, it’s really about understanding what you own and why you own it, as well as having a diversified portfolio.
Case in Point: The Great Recession
The evolution of the Great Recession illustrates the difference between market risk and monetary-policy risk. Initially, when stocks fell off a cliff in 2008, companies experienced market risk as share prices plunged. Monetary risk wasn’t an issue because monetary policy was cutting interest rates and injecting billions of dollars into the financial system to help the economy regain its footing. So, in 2008, your bonds (which gained value in a falling-rate environment) were helping to offset the market risk of your stocks. However, after several years, as the economy started to gain traction, the Fed started to normalize policy by inching upward the rates they’d cut to nearly zero. At this point, bond portfolios started to become subject to monetary-policy risk, which was especially great for longer-term bonds. It was therefore important not to reach too much for yield, which could have incurred greater interest-rate risk. This is an excellent example of why risk vs. return considerations depend on the economic environment at the time. Think back to the tech bubble and the euphoria of imagining that anything you bought was going to be a winner. People flooded into the day’s hot investments, similar to what happened with housing in the run-up to the housing crisis. Taking the measure of such investments by calculating their standard deviation provides insights into the real risk that the volatile assets that worked today and over the past few years aren’t necessarily going to be the best-performing assets or asset classes for the foreseeable future.
Managing Risk in Measured Amounts
In terms of specific stocks today, examples that come to mind are the FANG firms: Facebook, Amazon, Netflix, and Google. Microsoft sometimes gets included in this group too. They’re great companies, but their success means that many people have most of their portfolios tied up in these stocks. Understandably, advisors invest in a few of these companies too, but the risk suggested by their standard deviations drives advisors to ensure they’re a very small part of their clients’ portfolios. It’s all about managing risk so that it’s not concentrated in large positions of volatile stocks, but well distributed so that some of your holdings are likely to zig when others zag.
Detecting Portfolio Risks
As advisors aim to balance both risk and diversification in their clients’ portfolios, one of the specific things they look for are concentrated positions. This simply means an individual investment that represents a significant percentage of a portfolio’s total asset value. This may be because the asset has appreciated greatly and grown faster than other components of the portfolio. Often, however, it’s because it’s tied to stock options, restricted stock, or an Employee Stock Ownership Plan (ESOP) in a company the portfolio owner works for. You may also have a psychological bias in favor of that stock or some other hurdle that’s preventing you from selling it and reducing your risk. An objective, independent financial advisor can identify potentially problematic investments such as this, helping you take whatever actions may be in your best interest.
Why a Concentrated Position is Riskier Than a Diversified Position
Any concentrated position magnifies whatever risks are inherent in that investment. It’s also important to realize that those risks may not always be obvious. Just recently, for example, trusted, blue-chip names such as Boeing and General Electric have appeared in the news for all the wrong reasons. These were companies purchased for income stability—all-weather plays that might lose a bit along with the overall market when it dipped, then recover while continuing to issue a dividend. However, bad headlines have revealed that these companies held considerable stock-specific risk, and the greater their concentration in a portfolio, the more they subsequently dragged down its overall value.
Two Strategies for Single Stock Diversification
One way to exchange funds for concentrated positions and lessen their impact is to work out a plan to diversify by progressively selling such investments over a period of years. This may involve looking at when it’s advantageous to sell high-cost-basis or low-cost-basis shares, as well as how much you can sell in a given tax year. You can then invest the proceeds of these sales in other sectors of the market. Selling shares over time also means you can maintain a certain amount of exposure, meaning you can benefit if the stock continues to rise. This amounts to dollar-cost averaging out, just as dollar-cost averaging into a position also helps you trade more shares at more favorable prices. Finally, depending on how rapidly the risk suggests you may want to reduce or exit the position, a charitable donation of shares may be an option worth considering to help minimize taxes. In addition to divesting your portfolio of shares in the concentrated holding, a complementary strategy is to diversify money in other parts of your portfolio into investments in different market sectors. You may even want to move money out of stocks altogether and into another asset class.
Assessing Your Risk Tolerance
Whatever stage a market may be in, it’s good to take a look at your risk tolerance and assess whether your current portfolio is appropriately constructed. If you haven’t seen a steep selloff in some time, it’s easy to say, “Yeah, I can handle some risk. I can handle a 20 percent or 30 percent drawdown.” But can you really? In many cases, when people actually see some volatility, they realize their risk tolerance isn’t as high as they thought it was. Consulting an independent financial planner can help you take an objective look at all the components of your portfolio, including concentrated positions, in light of your individual investing goals. In addition to providing an opinion on the risk/reward merits of a stock you may like—or may have doubts about—a financial advisor can assess how that position fits into your overall financial plan. Perhaps most importantly, they can also show you a simulation that quantifies the impact of a negative event, such as those that struck Boeing and GE. In many cases, actually seeing that impact on your portfolio, and how it can derail your long-term financial plan, can be an eye-opening inducement to address a concentrated position before it causes problems.
Capturing the Upside in a Down Market
If the market is down, you may find yourself holding less in stocks—and therefore have less upside potential in a market rebound—than your risk tolerance might support. Regularly reassessing your financial plan, or creating a plan if you don’t already have one, lets you simulate what various market scenarios can do to your portfolio. Doing so can go a long way toward helping you make the right moves, meaning you don’t make potentially costly missteps when the market throws you a curve.
Building an Investment Portfolio: How to Buy Stocks
A Strategic Approach to Buying Stocks
An advisor’s process for selecting equities for client portfolios demonstrates which factors to consider when buying a stock. This starts at the investment-team level, where team members are assigned various areas of coverage—for example, consumer discretionary, real estate companies, or financial companies. In evaluating companies as potential stock purchases, there are three key criteria to look at:
What Is the Valuation?
In any market, and especially during bull markets, you want to be sensitive about the price you’re paying for a security. You want to make sure the valuation isn’t too lofty.
Is the Earnings Trend Positive?
It’s also key to ensure that the firm has positive earnings and that those earnings are growing to justify the company’s valuation.
Is There a Long-Term Catalyst?
Finally, for every stock, you want to look for a catalyst that can support its long-term growth. Amazon, for example, has shown its ability to expand its range of online businesses into the grocery sector.
Effective Tools Empower Stock Pickers
Advisors subscribe to a variety of information sources, including a quantitative research provider. They can screen for a range of factors, such as earnings momentum, management quality, price momentum, and valuations. Stocks are ranked with a letter grade: A, B, C, D, or F. A stock must usually hold an A or B rating to be in an advisor’s consideration set, which will narrow down the qualifying firms by about half. They will then drill down further into qualitative business characteristics, such as the presence of a catalyst, to select the one or two companies they would like to add to their clients’ portfolios. There’s so much financial information out there at all times that it can be hard to recognize when the real story isn’t necessarily what’s being conveyed by the headlines. To cut through the noise and get the real news, advisors need to drill down into the news they’re following to evaluate all the relevant information available. Only then do they gain a view of the bigger picture, which may be very different from what’s suggested by selected headline statistics. Take retail sales, for example. With consumer sales representing about 70 percent of the economy at the beginning of 2020, this was the major factor carrying the weight of the economy, with businesses on the sidelines waiting for trade issues to resolve themselves. Then a new retail sales number came out that appeared to be good—up 0.3 percent over the previous month. However, not every article carrying this news mentioned that only five of the thirteen retail groups reported growth over the previous month. This suggested that the outlook wasn’t nearly as promising as those initial headlines indicated and that perhaps the market was about to fluctuate in a more negative direction. Without digging for such comprehensive details, you may not have an accurate understanding of how current market conditions can affect your plans.
Building an Investment Portfolio: How to Buy Bonds
Analysis Is More Challenging When You’re Buying Bonds
Unlike the stock market, the bond market is not as transparent as advisors would like it to be. Stocks, particularly those of large-cap companies, are traded in huge numbers of shares every day. As a result, price information is easy to come by. However, unlike stocks, many bonds don’t trade at all on any given day. This makes it harder to determine what their true value may be.
How to Invest in Bonds at Better Prices
Also unlike stocks, buying bonds in smaller lot sizes—for example, ten bonds—can cause you to take a pretty big price hit compared with what you might pay if you were purchasing a lot size of fifty or a hundred bonds. When advisors construct a bond portfolio, they will therefore ensure it’s large enough to buy these larger lot sizes, while also investing in enough different bonds to provide diversification.
Better Information Provides Negotiating Power
Because larger institutional companies can often get better prices on bonds, advisors use several tools to help level the playing field. Resources such as Bloomberg provide trade-order history on individual bonds. Investing directly through electronic trading platforms allows an advisor to see what different dealers are offering—often, they’re offering the same bond at very different prices. By being able to see the markup they’re making, advisors can negotiate to add bonds to their clients’ portfolios at a lower cost.
The Two Ways to Maximize Yield
Investors typically gravitate toward bonds because they want income and safety. But the two different ways of maximizing yield each carry their own risks.
Longer-term bonds normally offer higher rates than shorter-term bonds. However, they’re also subject to the threat of rising interest rates, which cause the price the bond trades at to decline.
Lower-rated bonds with less credit quality also pay higher rates because of their greater risk of default. In maximizing yield on behalf of their clients, advisors focus first and foremost on credit risk. When buying a bond, they will look at its credit rating, its rating history, and any potential actions that may affect it. A bond that looks good now might be facing a potential downgrade by one of the major ratings agencies. Credit quality is where research can reveal red flags that may prove costly.
Summary and Conclusion
A diversified portfolio is one that is spread out across a variety of investments, which can include stocks, bonds, cash, and other assets. The main goal of diversification is to reduce risk by ensuring that your eggs are not all in one basket. Building a diversified portfolio is an important part of investing. By diversifying, you can reduce your overall risk and increase your chances of achieving your financial goals. A financial advisor is equipped to help you build out the correct portfolio to meet your financial goals. If you need assistance building a portfolio, you can find a financial advisor near you using the Finance Strategists advisor search tool.
Building Diversified Portfolios FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.