2 Simple Steps to Perfect Portfolio Diversification
Updated: Jul 9, 2020
"Diversify your portfolio." It's a phrase that has become so common that even people who have never invested a single dollar in their whole life will recognize it.
Diversification is a way of managing risk. "Diversifying your portfolio" is synonymous with the phrase "don't put all your eggs in one basket". If you have a dozen eggs and decide to carry them all in one basket, you risk losing all of your eggs if you drop the basket. If you have a dozen eggs and put each one in its own basket, even if you drop a basket and break an egg, you still have 11 more eggs.
The same concept applies to investing. If you take your life savings and invest it in a single company, what happens if that company goes bankrupt? You lose your life savings.
If you take your life savings and invest it in hundreds or even thousands of companies, what happens if one of those companies goes bankrupt? Probably nothing. The more you diversify, the less impact a single poor performing company or investment will have on your portfolio.
Diversifying your portfolio is a smart and simple way to manage investment risk.
But what does it actually mean to diversify your portfolio and how can someone without a background in finance diversify their portfolio in a smart and simple way? In this article, I am going to discuss two simple steps to perfectly diversify your investments.
Step 1: Diversify by asset class.
Step 2: Diversify by geography.
It's impossible to diversify through individual stocks
Before we discuss the proper way to diversify your portfolio, let's discuss why it's impossible to achieve diversification by investing in individual companies.
Let's say you just started investing and have decided to invest $100 per month moving forward. You plan on using that $100 per month to build a diversified portfolio of stocks. Then you start looking at the price of some of the most popular stocks.
Amazon: $1,880 per share
Microsoft: $162 per share
Netflix: $370 per share
Facebook: $192 per share
Disney: $120 per share
There are approximately 3,800 companies trading in the U.S stock market today. To simply buy one share of Amazon stock with $100 per month would take you 19 months. Unless you have a huge sum of money to invest, it is not possible to build a truly diversified portfolio by investing in individual stocks.
If you want to diversify your investments the simple solution is to invest in low-cost index funds. These funds, mirror the stock market and can often be purchased for less than $100. For example, if you bought a U.S total stock market index fund, you could invest in every publicly traded company in the U.S for a few dollars.
There are index funds for stocks in every country that has a stock market and for other asset classes such as bonds. Which brings us to the first step to properly diversify your portfolio.
Step 1: Diversify by asset class
The first step to a diversified portfolio is having your money invested in multiple asset classes. There are a number of different asset classes, but there are three tried and true asset classes that have been proven to help build welath in the long term.
While I am a big fan of real estate, I want to keep this discussion of asset classes focused on stocks and bonds for two reasons.
Stocks and bonds can be bought in mass through index funds. Real estate is an expensive physical asset, which makes it difficult to diversify. You can spend over $500,00 on a single property.
Bonds have historically acted as a hedge to stocks, making them a great asset class to diversify your portfolio.
Historically, when the stock market tanks, bond prices rise. Diversifying between stocks and bonds can reduce your overall level of risk and volatility in your portfolio. This is especially helpful when the market goes in the tank.
In the 2008-2009 financial crisis, stocks lost more than 40% of their value. While during the same time period bond prices increased. Having a section of your portfolio that increases in value during turbulent times can prevent you from making a fear-based decision of selling your stocks and turning a paper loss into a real loss.
How much should I allocate to stocks and bonds?
How much of your portfolio should be allocated to stocks versus bonds depends entirely on your goals, your financial situation and your ability to act rationally in the face of market meltdowns.
Personally, I invest 100% of my retirement savings in the stock market for two reasons.
I won't need this money for 20-40 years. So, even if the market tanks tomorrow I have multiple decades to make up any losses.
I have the stomach to withstand large drops in stock prices without panicking. When the market tanks, I don't think about getting out of the market, I think about how I can get more money in the market.
For short or medium-term investment goals, I invest a portion of my portfolio in bonds.
The question remains, how much should you allocate towards stocks and bonds and how do you figure it out?
If your working with a financial advisor, this is something they are paid to help you with. If you are a DIY investor, you might want to consider this questionnaire developed by Vanguard. You answer a few questions and based on your results, a particular asset allocation is recommended.
I went through the questionnaire and based on my answers, it recommended a 100% allocation to stocks. For most people, some allocation to bonds makes sense. Give the questionnaire a try and see what allocation between stocks and bonds is recommended for you. If your comfortable, share your results in the comments, I'd be curious to see if you agree with the results you get.
Once you have figured out how much of your portfolio should be allocated between asset classes like stocks and bonds you have completed the first step of diversifying your portfolio.
Step 2: Diversify by geography
Let's return to the metaphor of not putting all your eggs in one basket. When it comes to diversifying your portfolio that has two meanings.
Don't put all your money into one asset class.
Don't put all your money in one country.
In step 1, we covered how to avoid putting all your money into one asset class. Now let's discuss why it's important to diversify by country as well.
If you live in the U.S, chances are that most of your money is invested in U.S stocks and U.S bonds. Which makes sense. People invest in what they know because it makes them feel safer.
However, having all your money concentrated in one country opens you up to risk. At the beginning of this article, I made an analogy about investing in individual stocks. If you invest all of your money in a single company and that company goes bankrupt or simply underperforms, your portfolio will suffer.
The same is true for the geography. If you invest all of your money in a single country and that countries economy suffers, you will have poor investment returns. If you have your money spread throughout multiple countries, even if one country is underperforming that might be offset by another country outperforming.
Beyond gaining exposure to other economies a globally diversified portfolio can ensure you don’t miss out on the companies that will drive the stock market in the future.
In a paper written by Vanguard in 2019, their research determined that investors who allocate roughly half of their portfolio to international stocks experience the least volatility. This finding fits with the theory of diversification. A well-diversified (which includes global diversification) portfolio will be less volatile than a highly concentrated portfolio.
What about bonds?
Investing some of your allocation to bonds to international bonds can also reduce the overall level of volatility in your portfolio.
This graphic from Vanguard shows the overall volatility of bonds in the U.S, Canada, the U.K, the EU, and Australia.
The results clearly show that a global bond fund that is hedged to an investors local currency reduces the volatility of bonds within a portfolio.
Here’s why that is.
Bonds are very sensitive to interest rates. When rates rise, bond prices go down. When rates fall, bond prices go up.
If an American invests in a U.S bond fund and the Federal Reserve increases interest rates, bond prices will go down.
If an American invests in a global bond fund, hedged to U.S dollars and the Federal Reserve increases interest rates, the global bond fund may not go down if the other countries in the global bond fund do not increase interest rates.
A word of caution. It is important to ensure any global bond fund you consider is hedged to your local currency. If it is not, you introduce exchange rate risk and the volatility of your portfolio will increase.
Since one of the primary goals of bonds is to reduce portfolio volatility, Vanguard research suggests it makes sense to have exposure to a globally diversified bond portfolio that is hedged to your local currency.
A truly diversified portfolio involves investing your money in multiple asset classes and multiple countries. That may sound complicated, but there are plenty of funds that invest in the entire global stock market and the entire global bond market. That means you could diversify by asset class and geography with two funds.
In fact, it can be even simpler. There are even "one decision" funds that allow you to diversify by asset class and geography by investing in a single fund. You can get exposure to thousands of stocks and bonds in multiple countries in a single fund. It has never been easier for DIY investors to fully diversify their portfolio.