How do you build a diverse investment portfolio? Hint: Diversification works because not all asset categories are positively correlated.
When I started investing at the height of the weed stock bubble in 2017, I foolishly put all $1,000 of my investable cash (#brokestudentvibes) into Maple Leaf Green World (#canadianvibes)—a pump-and-dump penny stock with dubious financial disclosures and shady management.
A year later, I watched as the stock topped $9 a share before cratering to wipe out my investment. At the time of publication, MGW trades at $0.13 a share. I still keep those shares in my portfolio as a reminder that proper asset allocation and diversification are a must.
What are diversification and asset allocation?
You’ll often hear that diversification is about not putting all your eggs in one basket. It’s tempting to make big bets on one or a couple of stocks when you’re sure they’ll make your brokerage account explode, but that’s just as likely to leave you staring at a big red downwards trending chart wondering where all your money went. That’s an oversimplified explanation, though.
Diversification is the process of allocating your investment assets in a way that reduces exposure to any particular source of risk.
What is the purpose of diversification?
Why should an investor consider diversification and asset allocation? It maximizes the potential of your portfolio and leads to better investment outcomes.
Diversification works because not all asset categories are positively correlated. Some are uncorrelated, and others are negatively correlated. Some zig when others zag, if you will.
By mixing and matching assets, you can construct a portfolio that either produces higher returns for the same risk, or the same returns for lower risk compared to any single asset. This is the art of optimizing risk-adjusted returns, commonly measured by the Sharpe ratio.
Here are some tips to build a diversified portfolio.
Don’t bet on individual companies
Some investors prefer to pick their own stocks. They spend hours poring over 10-K reports, listening to earnings calls, and following the financial news. Unless their name is Warren Buffett, chances are high that they will underperform a simple index fund even if they work as a professional fund manager, according to a Morning Star report on the matter.
Don’t just invest in the US market
Diversifying geographically is important too. The US stock market comprises around 55% of the total world stock market by capitalization, but most American investors overweight it at around 82% of their portfolios. This is called a home-country bias.
Take a look at this backtest from Portfolio Visualizer that compares the US vs global ex-US stock markets from 1986 to 2022:
You can see that they take turns outperforming. Young investors may have enjoyed a decade of US outperformance from 2012 onwards, but older investors shudder at the thought of enduring a period like 2002 to 2009 when international stocks handily beat US stocks.
Unless you have a solid thesis for betting solely on the US that the very efficient market hasn’t already priced in (spoiler: It knows literally everything), consider sticking to some degree of global diversification.
Consider more than just stocks
Young investors often invest all their money in 100% stock, which is inefficient. The performance of different asset classes vary, and adding a volatile non-correlated asset like US Treasurys or gold can significantly optimize risk-adjusted returns, especially if you rebalance your portfolio periodically.
Here is a backtest of two portfolios against one another: The blue line is a classic 60/40 portfolio of the total US stock market and long-term US Treasurys with quarterly rebalancing. The red line is just the S&P 500 Index.
Notice how close they are despite portfolio no. 1 having a 40% bond allocation. The negatively correlated Treasurys did two things:
As a result, the 60/40 portfolio produced more units of return for less risk, with a better Sharpe ratio of 0.61, compared to the S&P’s 0.53. It had nearly the same return (10.62% vs 11.67%), but far lower volatility (10.43% vs 15.08%). The best years for both portfolios were close, but the worst year for the 60/40 was more than half as low as the S&P 500. Boom. This is the efficient frontier at play.
An example of a diversified portfolio
Our goal with this portfolio is to maximize our Sharpe Ratio (more return for less volatility), minimize drawdowns, and mitigate some of the asset-specific risks talked about earlier.
This portfolio is meant to be a one-size-fit-all holding, agnostic as to what the future macroeconomic scenario looks like. We don’t know what will happen, which is precisely why we want maximum diversification to account for all contingencies.
Take a look at this portfolio’s returns compared to the S&P 500 since 2001. We see a much better Sharpe ratio, significantly lower drawdowns and volatility, and a less-severe worst year. An investor in this portfolio would have seen a smoother sequence of returns, which makes it easier for most to “stay the course” and remain invested during bear markets and crashes.
Are you diversified yet?
Your honor, I rest my case. Even for young investors with a high risk tolerance, diversification makes sense. While you can maximize your returns by going all-in on a single stock, the tail risk you’re exposed to has a high chance of wiping out your portfolio altogether. You might as well go to the casino and bet your Roth IRA on a single Blackjack hand instead.