Why and how to construct a diversified portfolio
Updated: Aug 25
a diversified portfolio can experience smaller losses during unexpected market drawdowns, and still perform well in the long run. Diversification is a very inexpensive form of protection.
by mixing together appropriate amounts of different asset classes, you can improve the overall resilience of your portfolio. Equities, Treasury Bonds, and Cash make up the most common constituents. Commodities, Credit and other asset classes are often added in the mix depending on each investor’s preferences
diversification is for everyone! From very active traders to long-term investors who save a little every month, diversification helps market participants deal with unexpected shocks.
Why construct a diversified portfolio
Diversification offers one of the most effective and inexpensive ways to reduce drawdowns during unforeseen market disturbances - and still capture compelling returns!
Diversification’s “secret ingredient” is that different asset classes might behave differently during the short term ... and yet go up together in the long term!
Equities and government bonds are the most important example of this phenomenon. For the last several decades, these two asset classes have been great at helping each other out: when equities fell, treasuries went up and vice versa. Yet in the long run they both delivered positive returns for investors: the growth of equities plus the interest of bonds, with risk lower than each one individually!
How to construct a diversified portfolio
Constructing a properly balanced portfolio is very much like cooking, we need the right ingredients in the right amount. Let’s run through an example.
Premise. It’s about you
This exercise revolves around you and the two key investment questions: what is your risk tolerance and what are your preferred asset classes.
Determine your Investment Capital
This is not just the money you want to invest in your portfolio, but also other liquidity you might want to use for other reasons.
Let’s say you have liquid savings of $10,000, of which $3,000 constitute an emergency reserve you wish to leave in cash. You also want to use $1,000 for active trading in more concentrated positions. That leaves you with $6,000 to invest in a diversified portfolio, to which you plan to add on a monthly basis.
Determine your Investment Horizon
Are you saving for retirement in 30 years or for college in 2 years? Shorter time horizons inevitably imply lower tolerance for risk.
In this example, your goal is to make a down payment on a house in 5 years. This will be a major factor in determining your allocation because your horizon will become considerably shorter as time progresses, changing your risk preferences.
Determine your Max Acceptable Loss
What is the most you are willing to lose on a temporary basis? Your emergency fund has a different risk tolerance than your retirement money.
This is a key question that requires you to think about your financial as well as emotional constraints. Let’s say that for the time being, during the deepest recessions you need to still have 80% of your capital - i.e. you don’t want to lose more than 20% peak-to-through.
Determine your Investment Universe
Are you focused on US equities? Are you interested in gold and other commodities? Investing in assets that you follow will allow you to better understand their performance.
Let’s say you follow markets regularly and have a good grasp of US large caps and tech stocks. You also have consistently followed the Gold market and feel that should be part of your portfolio. You also own a $600 of Bitcoin that you plan to keep in this portfolio, as the cryptocurrency becomes more accepted as a liquid investment - but you don’t want to increase this amount.
In addition to these assets, it is quite common to include US Treasuries and Cash as components of the portfolio - the former offers a form of insurance that pays dividends, and the latter offers dry powder to invest when markets fall.
List your boundaries
Are there limits to how much you want to be exposed to risky assets? Maybe you don’t want to have too much cryptocurrencies, or conversely, you want to have at least a certain amount of your portfolio invested in equities.
In this case, you want to cap your Gold exposure to 10% and you want at least 30% in equities.
Put it all together
Now you have all the elements you need to construct a nicely differentiated portfolio. It’s time to decide how these pieces of the puzzle fit together.
Usually, at this step you would be using an optimization tool, but we can do a lot even with back-of-the-envelope calculations.
My capital: $6,000
My asset classes: US Equities, US Treasuries, US T-Bills, Gold, Bitcoin
My risk preferences:
lose 20% maximum in a hard recession
set equities to at least 30% of your portfolio
limit Gold to max 10% of portfolio assets
Set BTC equal to current amount ($600)
Remembering that equities have historically lost up to 40% of their value in the most vicious crisis, and that longer treasuries gained 10% plus in the same period you can structure a first draft of your portfolio as:
US Equities 30% $1,800
US Treasuries 40% $2,400
US T-Bills 10% $ 600
Gold 10% $ 600
Bitcoin 10% $ 600
You can already see that during the hardest crises your portfolio might have lost something like 12%, and that’s a good starting point because you need some margin of error - as the next crisis may be dissimilar from the past ones.
This portfolio becomes part of your broader wealth allocation:
My Long-term Portfolio 60% $ 6,000
My Actively Traded Portfolio 10% $ 1,000
My Emergency Reserve 30% $ 3,000
You are starting to think like Warren Buffet! Fun, isn’t it?
And the fun has just begun, you have more work to do. For example:
Now you have a 30% bucket allocated to US Equities, what are you going to put in it? A diversified S&P 500 ETF? Or a more concentrated portfolio of equities, maybe selected to have a value bias. Be careful because a more concentrated portfolio will carry more risk, and might force you to reduce your equity exposure
About that Treasury exposure, maybe you want to think about including also some AAA corporate bonds to get more yield? They are as almost as safe as the Treasury bonds and carry a bit more yield
What comes next: doing it with the right tools
Constructing portfolios requires tools for optimization that will allow you to put smarter constraints on your portfolio and check on it recurrently. Stay tuned for an exciting announcement about this from us.