How to build a diversified investment portfolio

By Jon Scott

  • What does diversified mean? How do different investments interact to either reduce your beta to a specific market, protect you from downturns, etc

  • What are some essential components of a diversified portfolio?

  • What vehicles are best for a passive, low-management portfolio? You can link out to ETF/funds article

Abstract: This article focuses on the various ways to build a diverse portfolio and the different assets classes needed to create a diverse portfolio. This article also explains how portfolio needs change as an individual's age and working situation changes as well.

Diversity is a word thrown around in almost every sphere of life–but what does a diverse portfolio look like when investing? At the most basic level, having a diverse portfolio means minimizing risk. When a certain asset class or specific elements of one asset are not doing well, is your portfolio diverse enough to minimize losses? Diversification across assets means investments in stocks, bonds, and even alternative investments.

Essential components of a diversified portfolio

There are two assets that are absolutely necessary in a diversified portfolio: stocks and bonds. Though a truly diversified portfolio will have more than these two assets, stocks and bonds are the building blocks every portfolio will usually have due to their liquidity, exposure to a variety of market forces, and continued relevance. In contrast, alternative investments lack liquidity and often affected by very specific events (regulation, changes in taste, advances in technology render that asset out of date) rather than larger economic forces.

Beyond stocks you will want to branch out into other assets including alternative investments like real estate. For investors with a large amount to invest, there are other potentially lucrative alternative investments including cryptocurrency, private equity, commodities, collectibles, hedge funds, and more.

How does diversification protect me from downturns?

Diversification is especially useful when invested across asset classes. For example, while the housing market and stock market decreased in value significantly during the Great Financial Crisis, U.S. Treasuries, gold, and hedge funds all performed well, relatively speaking. In sum, diversification will not stop you from losing any money during a downturn, but it can and likely will drastically reduce losses in a downturn.

Diversification is just as useful coming out of recessions as well. In the depth of the housing crisis, the median home price reached a low of $208,000. Fast forward to the second quarter of 2022, and the median home price soared to $440,300. By this logic, even though home prices took a dip in the Great Recession, it would still be beneficial to hold on to a slice of real estate in your portfolio to realize the gains that would come in the next decade and beyond.

How do I determine the level of diversification for my portfolio?

Diversification largely depends on two things: age and risk tolerance.

Age

Age is the most important factor. For example, an older (59 ½ or older) individual on the edge of retirement or in retirement does not have the luxury of another 20 or 30 years of working to see investment returns in the case of an economic downturn that wipes out a large number of investment gains. The result is that a retired individual will most likely have a greater degree of investments in cash and bonds than a younger worker, since these assets do not carry the same risk of losses as stocks.

Therefore, an older individual may choose a diversification similar to the strategy below:

In contrast, a new graduate entering the workforce will have a more aggressive portfolio made to maximize gains. The stock market is prone to negative swings, but, over the long run, the stock market is the best vehicle for most individuals to see large gains over a large period of time.

Risk Tolerance/Investment Goals

Quite simply, risk tolerance is the amount of risk an investor is willing to take. In practice, an investor with a risk tolerance may skew more toward stocks or alternative investments such as real estate, private notes, and collectibles (art, cars, NFTs–to name a few).

Investors with higher risk tolerance may also choose to skew towards riskier assets, but within the same asset class. For example, instead of investing in relatively less volatile ETFs such as the Vanguard Total Stock Market Index (VTI) or SPDR S&P 500 Trust (SPY), an investor with a higher risk tolerance may choose a riskier ETF such as the ARK Innovation ETF (ARKK) or a bundle of individual stocks including Apple (AAPL) or Microsoft (MSFT) and/or include riskier higher volatility stocks in their bundle like Tesla (TSLA) and Block (SQ).

Your Next Steps

  • Evaluate your age and investment goals

    • Do I want to retire early/am I near retirement?

      • If so, you will want to pick a conservative strategy with a larger allocation toward bonds and less volatile stocks

    • Will I be working a long time into the future, and am willing to take on risk for large returns?

      • Your portfolio should be skewed toward equities and potentially even alternative investments with higher-risk reward