For steady income without devastating drawdowns, you have to diversify your portfolio. That’s something your wise father and grandfather might have taught you. Or you might have heard about it from money managers. Diversification truly is a mainstay of traditional investing.
However, it’s not just for traditional investors. Modern investors with apps should diversify their assets, too. The last thing you’ll need during a market downturn is a lopsided portfolio. And having a mix of different types of assets will reduce the damage and smooth out your overall performance.
You might think that spreading your holdings across multiple asset classes is hard. And if you choose to let a money manager do it for you, that’s perfectly fine. Yet it’s also entirely possible to handle this job yourself. Like a chef, you can mix the ingredients of your portfolio in just the right amounts. To start, you just need to follow a simple recipe. Here are a few easy steps to get you started.
What is portfolio diversification?
The basic idea behind portfolio diversification is to have multiple types of assets that are fundamentally different. Variety is the spice of life, but you’re not really trying to spice up your investing account here. With diversification, you’re trying to make it steadier and more balanced.
Unfortunately, many people wrongly believe that their investing account is diversified. For example, maybe someone bought shares of an exchange-traded fund or ETF. That’s like a mutual fund that you can buy and sell easily during market hours. And a very popular ETF is the SPDR S&P 500 ETF Trust (SPY), which includes 500 famous large-cap companies’ stocks.
So perhaps someone put all of their investment account into SPY shares. That sounds diversified, right? After all, with 500 different stocks, how can you go wrong? You’ll participate in the ownership of a variety of giant American companies, like Apple (AAPL), Coca-Cola (KO), Microsoft (MSFT), and Verizon (VZ).
And yes, you’ll get some diversification with shares of SPY or another ETF that tracks the S&P 500. I would actually consider buying some shares of SPY or a similar ETF as a pretty good start to portfolio diversification. However, that step isn’t enough diversification by itself, in my opinion.
If there’s a stock market crash, no company in the S&P 500 will be immune. They’ll all go down together—like they did in 2000 and 2008. Some stocks will go down more than others. But most people wouldn’t want to deal with a 50% drawdown in their portfolio. That’s what happened to the S&P 500 in the two crashes I mentioned above.
And we can say the same for similar index-tracking ETFs. There’s the SPDR Dow Jones Industrial Average ETF (DIA), which follows the Dow Jones Industrial Average, and there’s also the PowerShares QQQ Trust (QQQ), which follows the tech-heavy Nasdaq 100. So, whichever broader-market ETF you might be considering, don’t assume that buying a basket of large-cap stocks is enough diversification.
A traditional diversification strategy
To achieve true portfolio diversification, you can look beyond index ETFs. Money managers will often recommend a 60/40 portfolio. That’s 60% large-cap stocks (you can use SPY shares for this) and 40% bonds. That 40% can be U.S. Treasury bonds, which have many duration options such as 10, 20, or 30 years. Or you can use the iShares 20+ Year Treasury Bond ETF (TLT) instead.
The 60/40 formula can certainly work. And it’s actually not a bad strategy for retirement income. Just be aware that U.S. Treasury bonds yield very little. As I’m writing this, a ten-year Treasury bond only yields 1.92% annually. That rate is less than the annual US inflation rate, which is currently 2.1%.
Using the traditional 60/40 formula will provide some cushioning during a stock market crash. And US bonds tend to hold up well during financial crises. However, the paltry yield in bonds means low portfolio returns over the years. So I only recommend the 60/40 strategy for highly risk-averse investors.
An alternative diversification strategy
If you don’t mind taking on more risk, you might achieve better overall returns. And you still use an online brokerage account for this approach. However, you’ll need to start thinking outside the box. It’s time to consider asset classes that traditional money managers don’t often recommend.
For instance, you could add some precious metals to your portfolio. And it’s possible to buy physical gold and silver through a trustworthy dealer. However, not everyone wants to bear the costs of shipping, safekeeping, and insurance. But fortunately, there’s an alternative way to participate in the price action of gold and silver.
Again, ETFs are an easy solution here. Remember: you can buy and sell ETFs during market hours through an online broker. A popular ETF that follows gold prices is SPDR Gold Shares (GLD). For an ETF that follows silver prices, there’s the iShares Silver Trust (SLV).
Like bonds, gold and silver tend to do better than stocks during a stock-market crash. One of my favorite strategies is to combine SPY shares with some GLD and SLV shares. I’ll also include some TLT shares and some cash. And the cash isn’t just for safety during a market crash. It’s also to use as “dry powder” for buying more SPY shares when they’re cheaper.
This portfolio diversification strategy won’t be right for everyone, but here’s an example:
- 40% SPY shares.
- 15% GLD shares.
- 15% SLV shares.
- 15% TLT shares.
- 15% cash.
Or perhaps you’d like to be a “stock picker” and select some individual companies’ stocks for your portfolio. In that case, here’s a variation on the previous allocation strategy:
- 20% SPY shares.
- 20% individual large-cap stocks (AAPL, KO, MSFT, et cetera).
- 15% GLD shares.
- 15% SLV shares.
- 15% TLT shares.
- 15% cash.
Diversify for long-term prosperity
So let’s recap. You’ll want to consider whether your portfolio would have a “cushion” during a stock-market crash. And you can also think about combining traditional methods (like bonds and cash) with alternatives (gold, silver, and individual stocks). Finally, put some serious thought into how much risk versus reward you’re willing to accept.
Over the long term, diversifying your portfolio should reduce volatility and help you stay relaxed and confident. In finance, as in life, you’ll find that variety is indeed a very good thing.
Thinking about financial prosperity beyond your working years? Check out my guide for a DIY approach to retirement investing.