In my previous article, I wrote about the common mistakes that beginners make when creating a diversified portfolio which resulted in them building an investment that's not really diversified. That is, unless they already did their homework and chose to invest that way.
In this article, I'll focus on the different ways you could consider to mix and match and form your definition of a diversified investment portfolio.
How much diversification is enough?
To understand how much diversification is enough for you, you need to first understand what asset allocation means.
Asset allocation is a process of balancing risk versus reward by adjusting the weightage of each asset in your investment portfolio according to your risk tolerance, goals and investment time frame. Our risk tolerance, goals and investment time frame changes over time so I would relook at my asset allocation every year or so to see if there's any need to change my asset allocation.
Once you know the ideal asset allocation that is suitable for you, you can then build an invesment portfolio around the asset allocation before diversifying it by spreading the investment capital between different types of investments within each asset class.
Sounds complicated right?
Don't worry, I'll break it down for you.
Here's a simple way to understand how much asset allocation you need for your investment portfolio.
Determine your portfolio asset allocation
If you have not tried planning your asset allocation before, an easy way to start would be to follow the typical '100 minus age' rule where you subtract your age from 100 and put the resulting percentage in equities which are riskier, and the rest in bonds or any investments that are perceived to be low risk.
For example, if you're 20 years old this year, the rule would mean to put 80% of your assets in equities and 20% in bonds.
The purpose of the asset allocation is just to help you strike a balance between the amount of risk you should be taking in your investment portfolio.
At my age, the '100 minus age' rule indicates that I should maintain a portfolio of roughly 60% equities and 40% bonds.
Tweak your asset allocation based on your preferences
With my more adventurous risk appetite and the shorter time horizon I have to invest my money, I opted for a more aggressive investment portfolio with 80% of my cash in equities and 20% in bonds with AutoWealth. Since my money in my SRS account can only be withdrawn when I reach 62, I invested all that money in a portfolio that allocates 100% of my capital in equities through Endowus.
You can click here to read more about my investment portfolio.
You know yourself best. Once you apply the '100 minus age' rule to yourself to roughly know how much you should set as your portfolio's asset allocation, you can then make adjustments to the result based on your goals and preferences.
What are the ways you can diversify your investment portfolio?
Now that we have a good understand about our asset allocation, how should we diversify our investment portfolio?
I recognise the fact that there are many ways to accomplish this and it's highly dependent on your own definition of what a diversified portfolio means to you.
In fact, the rookie mistakes that I wrote about in the previous article, would only count as mistakes for those who didn't do sufficient research when building their investment portfolio. But if you have already done your research and chose to build your investment portfolio that way, I don't believe anyone could say that you were wrong.
Here are a few ways you can consider to build a diversified investment portfolio. You can even mix and match a few of them to suit your needs.
Diversify across geographical regions
Diversifying across geographical regions is an underrated portfolio diversification tactic that helps to reduce risk and create opportunities.
If you ask many investors about their portfolios, it’s very likely that many of them would be over-exposed to one region, either Singapore or US. It often happens because we tend to invest in markets that we are familiar with but that creates a risk of market concentration in our investment portfolio.
Remember that I mentioned that I invested in the STI ETF when I just started building my investment portfolio? For the first few years, it was the only ETF in my portfolio and that market concentration costed me dearly with its under performance. If I had diversified my portfolio across multiple markets geographically, I would have easily generated positive returns year on year.
However, market concentration is not necessarily a bad thing. If you had only invested in the S&P500 over the past few year, you would have generated strong returns that even fund managers would be proud of.
But is it possible to invest in a single market over your entire investment lifespan and continue to generate good returns? Personally, I don't think so.
I chose to invest cash portfolio through AutoWealth as its portfolio allowed me to diversify my investments geographically. It reduces my risk of being over-reliant on the continued success of a single economy and also presents some unique opportunities to invest in other developing and emerging economies.
You can easily diversify your portfolio across geographical regions by examining the underlying investments in your ETF to see what companies is the ETF investing in. Thereafter, it you need distinguish at this point between where the companies are based and where their revenue comes from.
Taking Coca-Cola as an example. While we all know that it is an American company, most of its revenue originate from overseas sales. When analyzing the companies that the ETF is investing in, make sure to also investigate where the revenue streams of those companies come from. Once you have finished analysing, it will quickly become clear if you are overexposed to one specific geographical region.
You can also keep things simple by investing in a few ETFs that specifically invest in specific geographical regions and make specific allocations for each of them so that you know you are not overly concentrated in one region.
Diversify across sectors
The pandemic is the perfect case study to demonstrate why diversifying your investment portfolio.
But wait! Didn't I just mention earlier that COVID-19 is a market (systematic) risk that nobody could avoid that sharp drop in their portfolio valuation in March 2020?
That's still true. But if you had a sector-diversified investment portfolio, your portfolio would have already seen some recovery in its value because some sectors weren't as affected compared to the rest. In fact, some companies even benefited from the pandemic.
Below are 2 tables from S&P Global Market Intelligence that shows the top 5 industries most impacted by COVID-19 and the top 5 industries that were least impacted.
Were you able to predict which sectors wouldn't get hit as hard? Probably because they were mostly defensive sectors but would you have restructured your portfolio to take profit from the bull market and concentrate in these sectors? I highly doubt so.
But if you already had a diversified portfolio where the ETFs you invested in were already exposed to these sectors among others, your portfolio would have simply weathered through the turmoil better than others.
The table below from McKinsey & Company shows an indication that many sectors are going to take a much longer time to return to pre-COVID-19.
Are you going to build a portfolio with some of these sectors in mind, especially those that were projected to recover by 2023?
You could do that if that's what you want to do.
Personally, I'm too lazy to be picking stocks from these sectors so I'll simply ensure that my portfolio remains diversified across multiple sectors to capture any gains throughout the recovery phase.
Diversify by market capitalization
This is specifically for diversifying the equities portion of your portfolio. How do you allocate your capital to invest in equities, be it one or more stocks and funds? One way to think about this could be to diversify by market capitalization.
Market capitalization is the market value of a publicly traded company's outstanding shares. You can easily calculate the market capitalization by taking the share price and multiply that by the number of shares outstanding. But if you think of it from an investor sentiment perspective, market capitalization measures not only what the company is worth on the open market, but also the market’s perception of its future prospects since it reflects what investors are willing to pay for its stock.
Large cap companies, like Alphabet, Microsoft and Amazon tend to be more stable and less volatile during turbulent markets. However, they usually offer less potential for high growth when compared to mid and small market cap companies as they already make up a large part of the market share in their industry.
Small cap companies tend to have a greater chance of large growth in a short period of time.
Think of it this way. A small cap company with a market cap of $500 million is more likely to double in value than a large cap company with a market cap of $500 billion.
At the same time, small cap companies don’t receive as much analyst coverage as large cap companies and that gives investors opportunities to discover very profitable small cap companies that were unnoticed by many investors, yet.
But this doesn’t come without risk. Small cap companies are often a lot more volatile and while those that are diamonds in the rough would sparkle after a few rounds of polishes, there are also some small cap companies that either fail or remain status quo, resulting in underperformance for many years.
Mid cap companies as the name describes, seem to come in the middle. They might not become the top performers over short periods like small cap companies, but they have lower volatility than small cap companies and higher growth potential than large cap companies. This winning formula often translates into good returns for investors of mid cap companies if they stay invested over long periods of time.
To sum it up, think about how you want your equities portion of your portfolio to behave.
Do you prefer to be safer and less volatile (large cap companies), be slightly more volatile and be willing to hold for the long term for returns (mid cap companies) or make big returns in the short term (small cap companies)?
After thinking about what you want to achieve, you can decide how much of your equities portfolio to allocate to large, mid and small cap companies.
A balanced equities portfolio (purely an example, please do not follow) could look like this:
- 40% in large cap companies
- Vanguard Total Stock Market ETF (VTI)
- Vanguard S&P 500 ETF (VOO)
- 30% in mid cap companies
- iShares Core S&P Mid-Cap ETF (IJH)
- Vanguard Mid-Cap Index ETF (VO)
- 30% in small cap companies
- Vanguard Small Cap Value ETF (VBR)
- Vanguard Small Cap Growth ETF (VBK)
Please note that the ETFs mentioned above are just merely examples from ETFdb.com and you should do your own research to decide what stocks or ETFs to invest in.
Diversify by correlation
While the earlier asset allocation exercise helped us decide a simplistic split between equities and bonds, you can further taper and tweak your risk exposure by investing in different asset classes or different assets within the same asset class, that have different levels of correlation.
Sounds too cheem for you?
Let's look at the historical correlation chart from Guggenheim Investments.
How do you tweak your risk exposure by investing in different asset classes or or different assets within the same asset class?
Looking at the historical correlation chart above, we can see that the S&P 500 has a negative correlation with investment grade bonds, cash and currencies.
If you are invested in the S&P 500 and you find your portfolio too risky and would like to add a counter balance to your portfolio, you consider adding another asset class in your portfolio by injecting some funds into investment grade bonds, currencies, or simply holding cash. Your choice depends on what you have more knowledgable about.
But if you are comfortable with the risks but would like to taper down the risk level, you could inject some funds in international equities or REITs that are in the same asset class (equities) but are different assets with a high positive correlation with S&P500, but a little bit lower. That means their performance would move in tandem with your S&P500 investment but with lesser volatility.
Do bear in mind that when you invest in different assets and asset classes, they each have their own set of investment properties that could result in rise and fall of their prices. Correlation isn't everything and you should only invest in what you are knowledgable in.
Diversify based on investment goals
Everyone has different reasons for investing and different goals they want to achieve.
Some times, it's not possible to build a single investment portfolio that is able to achieve all your different investment goals because you may have a longer time horizon for some goals than others, and the amount of risks you can afford to take may also differ among goals.
Because of that, you should absolutely consider having more than one investment portfolio.
You could have an investment portfolio built to take lesser risks because you know you will need to withdraw the capital in a few years time and you cannot afford to have the portfolio take on too much volatility. As each year goes by, you would rebalance the portfolio by reducing the equities allocation and increasing the allocation to bonds to gradually reduce the risks that the portfolio undertakes.
This could be an investment portfolio for funds that you are saving to buy a new home in the next 5-10 years.
You could have another investment portfolio that you have structured to take on a whole lot more risk with 100% in equities which will fund your retirement in 20 years' time. Because of the much longer time horizon, you could afford to take on more volatility and ride out any short term market corrections.
It's okay to get it wrong
There isn't a one-size-fits-all approach to creating a diversified investment portfolio for every one and that's only that much human and robo advisors can do to make portfolio recommendations based on the information you divulge to them.
The thing about investing is that we usually don't get things right the first time round. And that's okay.
But you need to get started.
As you learn more and more aobut investing, you can gradually make changes to your investment portfolio based on the new information you have learnt to improve on your existing portfolio.
How does your investment portfolio look like right now? Share your thoughts with me in the comment section below.