You’ve probably had someone tell you not to put all of your eggs in one basket, and this is exactly what it means to diversify your portfolio. Consider this: if you invested all of your money in one stock and the stock price fell, you would lose your money. If you had a diversified portfolio that included many different investments, you may have gained money on other investments, even if the price of that one stock fell.
A diversified portfolio reduces an investor’s risk, as losses in one investment may be offset by gains in another. “Investment professionals will look at the correlation between assets -- that is, how closely the prices of two assets have moved together in the past. What is desirable is to hold assets in a portfolio that aren’t highly correlated to each other, and hopefully, when one investment is going down another investment is moving up,” said Robert Johnson, CFA and president of the American College of Financial Services.
Many investors think diversification is simply owning different types of assets, such as stocks and bonds. But it’s equally, and sometimes more important, to diversify within a specific asset class. If stocks make up a majority of your portfolio, you should own stocks across a variety of companies in different industries or countries and of different sizes. The same can be said of bonds and other types of securities.
A diversified portfolio will look different for every investor. Most individuals invest for retirement, and most portfolio advice is given with this goal in mind. If you are investing for other reasons, you may diversify your portfolio differently.
Age and Time Frame for Investing
Young investors or investors with long time frames should hold a higher proportion of stocks or risky assets than older investors or investors with short time frames. Longer time horizons mean investors can benefit from higher returns of riskier assets like stocks, while weathering short-term volatility. Older investors or investors with short time frames, who will be using their investment income soon, will want safer, less volatile investments, even if this means the returns are lower.
A good rule of thumb for diversification is to subtract your age from 120 to determine the percentage of your portfolio that should be equity/stocks. A 25-year-old investor may have approximately 95% of his portfolio invested in stocks and 5% in bonds. A 45-year-old may have 75% in stocks and 25% in bonds, and a 70-year-old may have half in stocks and half in bonds.
Risk tolerance can be thought of in two ways: the amount of risk someone is willing to take and the amount of risk they are able to take. The amount of risk a person is willing to take depends on an individual’s personality and behavior. Risk tolerance may also depend on investment goals. An investor saving for retirement may be comfortable taking on more risk than an investor saving for a down payment.
Even if an investor is willing to take risk, his ability to take risk depends on his current goals and financial situation. “Example, for someone who is nearing retirement needing to take income from their portfolio will not have as much ability to take risk as someone in their mid-twenties. Since the pre-retiree needs the money soon, their chances of that money lasting through retirement would be considerably less if we have a bad market in the first few years of their retirement. That's why it's prudent to ratchet down risk in investor portfolios as they approach retirement,” said Ben Malick, CFA and founder of Three Nine Financial.
Income, or human capital, can also be an important factor when deciding how to build your portfolio. “An advisor will calculate the present value of all future income flows (based on certain assumptions), and this number is considered the person's human capital asset. Since the young worker's net worth is likely made up mostly of human capital assets, the young worker can afford to take on much more risk with their financial assets than the older worker who is nearing retirement”, said Malick.
Other factors that may influence how you diversify your portfolio include your marital status and general market conditions. If you are married, your investment decisions may be a joint decision, taking into account your spouse’s risk tolerance, age and income. Some investors are particularly sensitive to market conditions; for example, some investors do not buy certain types of securities because the returns have been too low for their taste over the past several years. This doesn't mean that investors should sell investments if they suffer a loss -- investing decisions based on emotions, such as fear or worry, should be avoided.
Below, we have included several sample portfolio allocations for three different investors. These sample portfolios are meant to serve as informative tools only -- you should use the factors above to determine the right allocation for your portfolio. If in doubt, you can also talk to a financial advisor. Remember too that you should be diversifying among the types of stocks, bonds and other securities that you own.
The first set of portfolios is for an investor in his twenties, who is starting his career. Since he is roughly 40 years from retirement, he can afford to take on more risk in his portfolio, and we can see that stocks make up at least 90% in both portfolios. We’ve also included international stocks in the breakdown, as many investors choose to invest 20-40% of their equity holdings into international stocks to achieve even more diversification. International stocks do come with additional risks, as the exchange rate of foreign currencies and political issues in a country can affect the stock prices.
Sample Portfolios for Young Investor
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Our second set of sample portfolios is for the mid-life investor, who is around 40 years old and is almost 20 years into her career. She still has roughly 20 years before retirement, so she can take on some risk, but not quite as much as the younger investor.
Sample Portfolios for Mid-Life Investor
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Our final portfolio is for the pre-retirement investor, who is around 60 years old and reaching the end of his career. Retirement is only a few years away, and he cannot take on as much risk as the mid-life or young investor, because he needs a steady source of retirement income from his investments. In both portfolios, bonds make up at least 40% of the portfolio.
Sample Portfolios for Pre-Retirement Investor
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Some brokers and robo-advisors will offer portfolio allocation advice based on your age and answers to a risk questionnaire. This advice can be very helpful in picking the portfolio diversification strategy that works for you. We haven’t included alternative assets, such as Real Estate Investment Trusts (REITs) or commodities, in the sample portfolios above. Many investors choose to allocate a portion of their portfolios to these types of investments for added diversity.
Beyond diversifying among the types of assets you own, you also need to diversify within the types of assets. For stocks, it’s important to have stocks in your portfolio from a large variety of companies, including companies in different sectors or industries, such as consumer staples or materials; from companies of different sizes, such as large-cap or small-cap stocks; from companies in different countries and from companies that either have growth potential or good dividend yields. Similarly, you should have a variety of bonds in your portfolio, including Treasury bonds, municipal bonds, corporate bonds, bonds with different maturities, foreign bonds and high-yield bonds.
You may be thinking it would be impossible to buy that many securities. This isn’t the case. “You can achieve diversification by owning very few assets and can be highly concentrated (undiversified) by owning many assets. The best example of diversification with one investment is to own a diversified index mutual fund -- for instance, one that tracks the S&P 500. By investing in that security you own a piece of 500 different companies from many different industries. On the other hand, one could purchase ExxonMobil, BP, Chevron, ConocoPhillips and Occidental Petroleum -- five different companies -- and be highly concentrated in the oil sector,” said Johnson.
For these reasons, mutual funds and exchange-traded funds (ETFs) are very popular among individual investors. Funds allow you to own a small piece of tens or hundreds of different securities, making it easier to diversify your portfolio. Mutual funds and ETFs come with a variety of fees charged by the fund company and transaction commissions charged by brokerages (some brokerages may offer no-transaction-fee mutual funds or commission-free ETFs). A popular type of fund is index mutual funds and ETFs, which cover the market broadly or a specific index like the Standard & Poor’s 500 (S&P 500). Index funds typically have some of the lowest fees of any funds and many are well diversified because they follow broad market indexes.
An investor may choose to purchase a broad domestic stock index fund, an international stock index fund and a bond index fund to diversify her portfolio. She might buy an index fund that tracks the S&P 500 for her domestic fund, an index fund that includes stocks from all countries (except the U.S.) for her international fund and a fund that tracks the Barclays Capital U.S. Aggregate Bond Index for her bond fund. Even among index funds, there are many options as there are many different market indexes. If you’re considering investing in any type of fund, make sure to read the fund’s prospectus to understand the investment objectives, the components of the fund, policies and fees.
Finally, diversification can be spread out across any accounts you own. You may designate one brokerage or retirement account for bonds and another for stocks. Your total portfolio would still be diversified, but each account would only hold one type of security. Ultimately, the way you achieve a diversified portfolio is up to you, but it’s important that you are diversified correctly.