6 Steps to Build a Diversified Portfolio

I occasionally work with people who are just starting to invest and want to know where to even begin when putting together a portfolio of investments.  Keeping in mind that they are new to finance and investing, I spare them a trip through the past century of academic research and instead pass on this advice:

1. Don’t Try to Beat the Market

There is no evidence that anyone can predict which country, sector or stock will be the star performer in the future. The vast majority of professional money managers who attempt to “beat the market” underperform their benchmarks and charge a lot to do so. Choosing managers based on a recent track record of strong performance is likely to disappoint you. For this reason it makes sense to just passively “own the market” using index funds or index-like funds. (For more, see: 5 Things to Know About Asset Allocation.)

2. Own the Entire Globe

I think a great starting point for investors is to passively own the entire global stock (and bond) market. That means diversifying internationally too. The United States makes up about half of the world’s stock market and roughly a quarter of the world’s bond market. That is a lot for one country, but by investing only in the United States you are ignoring almost half of the investable universe in stocks and the vast majority of bonds.

By investing outside the U.S. you have many more investment options, in different countries and in different individual companies. Taking advantage of this larger opportunity set results in considerably more options to diversify your portfolio. The importance of diversification cannot be overstated.

3. Keep Costs Low

The expense ratio of a mutual fund is the cost you pay the fund manager to invest your money by running the actual investment fund. Though you don’t write them a check, you as an investor do pay them, the costs are just deducted from the fund’s assets and show up in the form of lower returns to investors. Passively-managed funds are less expensive because they do not use a bunch of manpower trying to identify the best stocks or hot sectors and beat the market.  

Look for expense ratios below 0.50%, even though it is pretty common to see expense ratios of 0.05% or lower these days. It is tough to make blanket recommendations, but just make sure you avoid the expensive “XYZ High Performance Fund” with a 1.5% expense ratio. (For more, see: Pay Attention to Your Fund’s Expense Ratio.)

You will also want to be conscious of turnover as well. Turnover is just another way of saying how often the fund buys and sells or “turns over” the investments in its portfolio. Higher turnover leads to higher transaction costs. Passively-managed funds are not likely to have high turnover as they aren’t trying to buy and sell securities to “beat the market.” Once again, it’s tough to make blanket recommendations, but be wary of turnover over 30%. With efficient, broad-market index funds it is not uncommon to see turnover in the low single digits.

4. Watch Out for Cash Drag and Style Drift

A lot of investment funds will hold cash in order to be able to “take advantage of buying opportunities.” The problem is, cash has zero expected return and is likely to just be a drag on performance relative to being fully invested in stocks or bonds.  It is also fairly common to see funds stray from their stated purpose - for example, a stock mutual fund holding a material amount of bonds or vice-versa. 

If you own a mutual fund to reap the returns of the stock or bond market, make sure it doesn’t hold a material amount of cash (over 5%) and that it actually owns the type of investments it claims to.

5. Target Higher Expected Returns

The only reason to make tweaks to a low-cost, globally diversified portfolio is if you can reliably target higher expected returns by investing in riskier asset classes. (For more, see: 4 Steps to Building a Profitable Portfolio.)

Nobel Prize-winning academics have studied stock returns extensively and have identified that some asset classes have historically provided higher returns than others. For example, over long periods of time small company stocks have historically provided higher returns than large company stocks.* This is not a departure from risk and return. Small stocks tend to bounce around a lot more than large company stocks, variability that, over time, you would expect to be compensated for as an investor.

The idea is to strategically pursue these "premiums" by devoting a larger portion of your portfolio to those asset classes than a simple market weight, but without betting the house on one premium or a single asset class. For example, if small companies make up 10% of the value of the stock market instead of holding them in their market weight of 10%, you might invest 20% of your portfolio (not 100%) in small company stocks to pursue the higher expected returns associated with them.*

6. The Truth Is Out There

I’m sure a lot of you are wondering how hard it is to find the info we mentioned. Fortunately it is all publicly available and easy to find using www.morningstar.com or www.finance.yahoo.com. Just type in the fund’s ticker symbol and you will be taken to a page devoted to that fund that is going to have all the information you want to know. It may be separated on different tabs so you may have to click around and dig a little bit, but it will all be there. Just remember to pay attention to:

  • Number of holdings
  • Expense ratio and turnover
  • Cash drag and style purity
  • Asset class (U.S. vs. international, small cap vs. large cap, etc.)

Final Thoughts

There are no special secrets, magic pills or golden tickets when it comes to investing, just rigorously studied principles that are likely to put the wind at your back. Do your homework and build a portfolio that is low cost, globally diversified, and style pure. You’ll be on your way to successful investing. (For more from this author, see: Minimizing Taxes on Your Investment Portfolio.)

 

Disclaimer:  Past performance is no indicator of future results. With all financial decisions, you should consult your own financial advisor or other financial professional.