5-Step Guide to Create a Diversified Investment Portfolio
- Diversify by stock position and market cap – For most people with little knowledge and interest in investing, index ETF is a low-cost and effortless way to start achieving portfolio diversification. However, most index ETFs tend to concentrate in large-cap stocks. A lack of exposure to mid- and small-cap companies could leave potential growth opportunities out of the reach of ETF investors. I recommend adding incremental small/mid-cap exposure to an index ETF portfolio.
- Diversify by geography – One should avoid having too much home bias in their investment portfolio – By market capitalization, US stocks accounts for 40% of all global equity markets, while European stocks account for 20%, and developed Asian stocks accounts for 18% of the total. While most developed markets ETF are well constructed, many developing market ETFs are not as diversified as they often heavily exposed to natural resources sectors, a small number of large-cap conglomerates or state-owned companies. For exposure in emerging market stocks, I’d recommend forming a custom portfolio that has less such biases and risk exposure.
- Diversify by asset class – Having a portfolio of global stock ETFs may not good enough for diversification purpose as global stocks tend to be highly correlated with one another especially during uncertain times such as in 2008. One should also consider investing in other asset classes with low correlation to stocks such as bonds, real estate, commodity and gold.
- Diversify by time horizon – It is important to have different investments that will play out over different time horizons. Some companies are in investment mode and do not show near-term earnings but are otherwise building significant economic value not being reflected in GAAP accounting figures. You want to have a mix of investment in established market leaders as well as high-growth emerging leaders of tomorrow. For affluent investors, I also recommend venture capital and angel investing as these investments have long time horizon and low correlation with the economic cycle.
- Watch out for commission expenses – If you plan on making a large, lump-sum investment, then paying an one-off commission to buy ETF shares makes sense. However, if you plan on dollar cost averaging into the market by buying small amounts on a monthly basis, ETF may not make sense for you. For example, assuming an $5 per trade commission, a single investment of $1,000 in an S&P 500 Index ETF would cost 0.5 percent of the investment.
The Bottom Line
Successful investing is not a sprint but a marathon that involves careful planning and discipline. The best time to create a diversified portfolio is before diversification becomes a necessity and when the economy is still strong. When constructing your portfolio, your investment decisions should be shaped by your goals, time horizon and risk tolerance. And remember that the longer your time horizon, the more you should focus on the long term and ignore the near-term headline news, so your investments can grow over time.
