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Building a diversified portfolio can seem like a daunting task since there are so many investment options. Here are three tips to make it easy for beginners to diversify
One of the quickest ways to build a diversified portfolio is to invest in several stocks. A good rule of thumb is to own at least 25 different companies.
However, it’s important that they also be from a variety of industries. While it might be tempting to purchase shares of a dozen well-known tech giants and call it a day, that’s not proper diversification. If tech spending takes a hit due to an economic slowdown or new government regulations, all those companies’ shares could decline in unison. Because of that, investors should make sure they spread their investment dollars around several industries.
One quick way to do that for those who don’t have the time to research stocks is to buy an index fund. For example, an S&P 500 index fund will aim to match the S&P 500’s performance. The benefit of index funds is that they take a lot of guesswork out of investing while offering instant diversification. For example, with an S&P 500 index fund, you’re buying shares of a single fund that gives you exposure to 500 of the largest public European companies.
Another great thing about index funds is that their fees — known as expense ratios — are very low. That’s because with index funds you’re not paying for the expertise of a fund manager who’s going to research and hand-pick investments for you.
Another important step in diversifying a portfolio is to invest some capital in fixed-income assets like bonds. While this will reduce a portfolio’s overall returns, it will also lessen the overall risk profile and volatility. Here’s a look at some historical risk-return data on a variety of portfolio allocation models:
| Portfolio Mix | Average Annual Return | Best Year | Worst Year | Years with a Loss |
|---|---|---|---|---|
| 100% bonds | 5.3% | 32.6% | -8.1% | 14 out of 93 |
| 80% bonds and 20% stocks | 6.6% | 29.8% | -10.1% | 13 out of 93 |
| 40% bonds and 60% stocks | 8.6% | 36.7% | -26.6% | 22 out of 93 |
| 20% bonds and 80% stocks | 9.4% | 45.5% | -34.9% | 24 out of 93 |
| 100% stocks | 10.1% | 54.2% | -43.1% | 26 out of 93 |
Data source: Vanguard. Return data from 1926 to 2018.
Although adding some bonds reduces a portfolio’s average annual rate of return, it also tends to mute the loss in the worst year and cut down on the number of years with a loss.
While picking bonds can be even more daunting than selecting stocks, there are easy ways to get some fixed-income exposure. One of them is to buy a bond-focused exchange-traded fund (ETF).
Investors who want to take their portfolio diversification to another level should consider adding real estate to the mix. Real estate has historically increased a portfolio’s total return while reducing its overall volatility.
An easy way to do this is by investing in real estate investment trusts (REITs), which own income-producing commercial real estate. The sector has an excellent track record. In the 25-year period ending in 2019, REITs, as measured by the FTSE Nareit All Equity REIT Index, outperformed the S&P 500 in 15 of those years and generated an average annual total return of 10.9%.
Several studies have found that an optimal portfolio will include a 5% to 15% allocation to REITs. For example, a portfolio with 55% stocks, 35% bonds, and 10% REITs has historically outperformed a 60% stock/40% bond portfolio with only slightly more volatility while matching the returns of an 80% stock/20% bond portfolio with less volatility.
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