Building an investment portfolio is a very personal process. Before jumping into a variety of different asset classes and market sectors, you need to first determine your overall goals and your tolerance for risk. Are you saving to buy a house in three years, or for retirement that may be twenty years down the road? The answer to such questions will help determine the type of investments you should consider.
Once you have your goals sorted out, you can start with the broadest level of diversification—different asset classes. The primary reason we allocate funds into different asset classes like stocks, bonds, and cash is to reduce the volatility inherent to each asset class. Let’s assume that you have a 10-year time horizon and are investing broadly toward maximizing your investments. After taking an investor questionnaire, you learn that you are moderately aggressive and prepared to put 75% of your portfolio into stocks and the remaining 25% into bonds. Now what?
Why Is Diversification Important?
It’s time to create a broad, well-diversified portfolio to help you reach your goals. You'll want to consider having a number of different holdings, as one of the main reasons to diversify is to avoid the risks inherent in owning one, or very few, individual securities. If you invest all of your money in one stock, you risk losing everything if that company goes bankrupt. If you invest in hundreds of different stocks and bonds instead, the effect on the overall portfolio of one company going bankrupt is likely to be minimal.
Being diversified also means having exposure to different parts of the economy, including various industries, sectors, and sub-sectors. It can also mean owning companies that range in size from “mega-cap” (Apple, Microsoft, and Exxon) down to smaller companies that you may not have heard of. For investors who want to diversify globally, having some exposure to companies with reach outside of the United States can be important, as well.
How to Build a Diversified Portfolio
So what types of investments might you use to build a diversified portfolio? One way is to purchase index mutual funds and exchange-traded funds (ETFs). On the equity side, there are several index funds and ETFs that track the S&P 500. But owning just the S&P 500 falls short of satisfying the requirements of creating a truly diverse portfolio. The S&P 500 comprises only large-cap domestic stocks, and it’s market-cap weighted, meaning the largest companies in the index maintain substantially more weighting within the index than the smaller companies. In fact, 20% of the S&P 500 Index value is driven by just 10 stocks.
To combat that issue and further improve diversification, there are ETFs and index mutual funds that can provide you with exposure to other major market sectors, including small and mid-cap stocks, growth and value indexes, and many international and global indexes. You can even find ETFs that focus on dividend exposure, emerging markets, and specific sectors such as technology and healthcare.
For true diversification, you will want to include other asset types as well, such as bonds. However, the characteristics of bonds are quite different from stocks, so you’ll want to consider factors such as credit quality and duration, in addition to market sectors and company size. Like stocks, ETFs can be a useful tool for obtaining broad exposure to the bond market. There’s a variety of “total bond market” ETFs out there that can provide you with a diverse portfolio of bonds packaged up into one index.
With regard to the cash portion of your portfolio, there are a few reasons why investors may choose to maintain cash balances. They represent the safest portion of the portfolio and can be used to purchase additional securities on market dips. Cash also provides liquidity in the event that funds are needed beyond what you keep in the bank for an emergency. That said, many investors choose not to keep too much cash on hand because cash may lose value to inflation over time. The cash allocation will generally be determined by an investor's risk assessment, investment objectives, and time horizon with respect to changing liquidity needs.
Creating a portfolio that reflects your traits as an investor is an important step towards achieving your financial goals. Keeping the portfolio low-cost and well-diversified should help to move your finances in the right direction over time.