Well.. what the heck is portfolio diversification anyway?
If you have some money and you want to discover the smart way to invest…well..this article is for you.
Whether you use exchange traded funds (ETFs) or index funds to create your portfolio, it is the process of portfolio diversification that matters.
…And we start this process by focusing on you..yes you!
How you design your investment portfolio is unique to you. Just as you don’t decorate your house like your friends or family members do, your portfolio needs to mirror your goals and objectives.
There are certain questions that only you can answer and they significantly influence the asset classes (more on that later) you need to construct a diversified portfolio.
What’s Your Time Horizon?
You have to decide on the length of time you plan to stay invested in the market, your time horizon.
…And you may have multiple time horizons for life’s multiple goals.
If you want to buy a house in 3 years and want to save for the downpayment, then 3 years is your time horizon.
On the other hand, if you are saving for your new baby’s college fund, you have a time horizon of 18 years and the portfolio you create and the investments you select will be different than if you could only stay invested for 3 years.
What Do You Want Your Money To Do For You?
What do you want to achieve: income and preservation of your money or growth of your capital.
Now that will depend on your goals.
If you want to save for the down payment of your new home that you will need in 3 years, you will need a certain required return on your savings to meet your goal of a down payment on an after-tax basis,
Your goal may be growth without excessive risk because of your short term horizon.
On the other hand, if you are in retirement, you may look to your portfolio for income to meet your monthly expenses. Your goal may be income generation and preservation of capital.
Are You A Risk Taker?
Generally returns are a function of risk. If you want to generate high returns, you have to take more risk.
Here again you have to know yourself. There are 2 aspects to risk:
Ability To Take Risk
Your time horizon and the size of your wealth primarily influence your ability to take risk.
Just as in life, the younger you are, the more risk you can take, so too in investing.
When you don’t need to touch your money for decades you have much higher ability to take risk than when you need your money in a couple of years.
The longer you can stay invested in the markets, the more you can withstand market gyrations and not feel compelled to sell your investments to cover necessary expenses.
Markets go up and down but if you don’t need to tap into your investments, you allow your wealth to rise when the markets moves up.
The size of your assets is another factor that influences your ability to take risks. If you have a large asset base, you can financially afford to lose more and still not negatively impact your lifestyle.
On the other hand, if you don’t have a large asset base, your ability to lose money in the markets is limited and hence your ability to take investment risk.
Willingness To Take Risk
Your willingness to take risk is based on your personality: are you habitually risk averse or a risk taker?
Have you had any childhood experiences that may have made you risk averse later in life? OR
How about a prior bad experience with the stock market? OR
Are you the type of person who has made money once in your life and have an innate confidence that you can make it again, if you lose it?
These and many other factors influence how much risk you are willing to take.
I know of several people with secure jobs and a very long time horizon and a much higher ability to take investment risks yet very little willingness to do so.
You have to know your risk threshold. For if you don’t, you might end up taking more risks in your portfolio than you can handle.
…And the worst part is: by the time you realize your lack of willingness to take risk, your portfolio is down double digits and you end up selling your investments at the worst possible time.
By then, your portfolio has shrunk in size and you are beset with regrets about the markets and investing possibly a very long time. Now that would be a shame!
I knew an individual who wanted to see his wealth grow and longed to invest in the stock market.. Every time we spoke, he discussed how he was waiting for the right time to invest.
His problem?: He couldn’t stomach the thought of losses that come with market drops. Whenever markets fell and provided him with an opportunity to invest, he experienced an intense fear of losing money and couldn’t pull the trigger, so to speak.
The Upshot: know thyself!
A Little Bit About Asset Classes
So let’s say you know how long you want to stay invested in the market, your risk preferences, your goals, what next?
You then have to know a little about the asset classes and how they can help you create a diversified portfolio and achieve your investment objectives.
An asset class is a group of investments that exhibit similar behavior. I have listed traditional asset classes and what investors aspire to achieve by investing in them.
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Developed Market BondsNow these asset classes can be further divided into sub-asset classes. For example bonds can be split into the following 3 categories
- Emerging Market Bonds
- Domestic Bonds
Even Domestic bonds can be further divided into categories that you may have seen being offered by your retail broker:
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Domestic EquitiesSimilarly Equities can be further subdivided into sub-asset classes such as:
- International Equities
- Emerging market Equities
The idea is to use these asset classes to create a well diversified portfolio that helps you achieve your investment objectives.
You can use ETFs or index funds to get exposure to these asset classes. I have included a few ETFs that track these asset classes.
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So you now know your investment objective. You also know about the major asset classes and the ETFs you can use to invest in these asset classes.
Let’s discuss the concept of diversification and how you can use it to create a well diversified portfolio to meet your objectives.
What is diversification?
The idea behind diversification is that you don’t invest all your money in one asset class just like the old saying that you shouldn’t put all your eggs in one basket.
Different asset classes behave differently. They don’t all go down or up together.
…and that’s why it makes sense to spread your wealth among these asset classes.
For example, generally, the relationship between bonds and stocks is that of a see-saw. When bonds fall in price, equities rally and vice versa.
This zig zag relationship is called ‘correlation’. It has a value of -1 to +1. Basically you would like your assets to be negatively correlated so if one asset class goes down, the other goes up.
If your portfolio has exposure to both equities and bonds, the bond portion of the portfolio may fall in price but the equity portion may do well, thus reducing the overall portfolio volatility.
Relationship between asset classes can change over time. Nowadays, for example, equity markets are making all time highs and bonds are rallying as well. That has historically not been the case.
You can create a diversified portfolio by including asset classes that have negative or low correlations with each other.
The table shows correlations among asset classes. You can view the detailed correlations among asset classes from Portfolio Visualizer here.
As you can see, Vanguard Total Stock Market ETF, which represents the Equity asset class, is negatively correlated with bonds and has almost 0 correlation with Gold.
Once you have a set of asset classes from which to create a well diversified portfolio, you have to decide how much to allocate to each asset class.
That’s where portfolio optimization comes in.
Portfolio optimization means that you invest in asset classes in such a way that the portfolio produces the expected return for lowest level of risk, thus resulting in an ‘efficient portfolio’.
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There are several tools that use mathematical techniques to spread money among the asset classes such that you can create an ‘efficient portfolios’ that match your investment objectives.
Say you want an 8% return. You can tell the model to show you how to spread your money among asset classes such that the risk is the lowest for your desired return of 8%.
Note: The future is inherently uncertain and no model can guarantee how future returns will shake out.
The idea of this approach is to make an educated decision: use historical relationships among asset classes to create a diversified portfolio that has the lowest risk for the return you desire.
Here at YourCapital, we select the asset classes for you and also use a model to create a well diversified ‘efficient portfolio’.
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You still have to provide information that is unique to your situation: your time horizon, goals and things like prior experience with markets. what you get is a portfolio that is tailored to you.
Unfortunately the math to create a well diversified portfolio is not something you can easily do by yourself in excel…And you shouldn’t have too.
Once you understand the concepts and what attributes affect your portfolio, you can use YourCapital or several other online services to help you construct an appropriate portfolio that matches your investment objectives.
Please let me know if you focus on portfolio diversification and how do you go about achieving it.