How to diversify your portfolio... the easy way
How to diversify a portfolio
Last week I wrote about the different types of diversification. To put it simply, there's quite a few. It can be exceedingly complex trying to figure out the best way to optimize your portfolio for growth and security.
Luckily, there are a couple of free tools that can make everything much, much easier. This is how I would diversify my stock/bond portfolio if I had to do it all over again.
Step 1: Know your goals
This is actually the most important step, and it has nothing to do with diversification. I've written in detail about my own process developing my investment beliefs, and how that led to the portfolio I have now.
For those without the time to read that post, I have an easy button. Imagine a simple sliding scale: 0 is no risk with no potential gain, and 10 is extreme risk with extreme potential gain (and losses). 0 would be an all cash portfolio, 10 would be all Bitcoin, or diamond mines in the Congo, or something equally ridiculous.
Obviously, most of us want to be investing someplace in the center. I approach this from the perspective of "how much could I lose before I start freaking out". Since my portfolio is only for long term capital appreciation, I could lose 30-50% and still sleep at night. On the sliding scale, I am an 8. Someone who would be comfortable losing 20-30% would be a 6.
Step 2: Use free tools like Personal Capital to find a base allocation for a diversified portfolio
I talk a lot about Personal Capital because it's my favorite financial tool. I keep track of my spending, investments, real estate, loans, credit cards and everything else in my financial life in one location. Plus, it's free. They make money off of clients who choose to buy wealth management services, but for those of us that just want to use their algorithms it's free.
Remember the sliding scale from step one? Personal Capital has essentially the same one under the "Investment Checkup" area, and once you enter your number into the scale it will suggest a target allocation across all of the different facets of diversification. To use the Investment Checkup tool, connect all of your investment accounts to PC by clicking the + icon. in the top left hand side of the screen. You can see it in the image on the left below.
After connecting your accounts, go to investment checkup through the menu under "Planning". Once you do this, you'll see your current allocation as below. Remember to select only the accounts you want to use for comparison as well, as PC will automatically include everything in your portfolio.
Personal Capital breaks everything out into an easy to understand comparison of current allocation and target allocation. Directly below the checkup, there's a slider to enter your desired risk/return ratio. I like to try different variations to see how the target allocation changes.
At the very bottom of the page, PC displays some suggestions for changing allocation to better match the optimized allocation they've developed with their algorithms and backtesting. After all, it isn't just about diversification but how to diversify in a way that will help you achieve your goals without exposing you to tons of risk.
Step 3: Tinker with your allocation using free investment tools like Portfolio Visualizer
Now, technically step 3 is optional but as someone who is really interested in investing, I think it's crucial. Portfolio Visualizer is the second free tool that I use on a regular basis to check on my investments and optimize my allocation and diversification.
I love Personal Capital but Portfolio Visualizer is a little less cookie cutter. It gives you the freedom to choose and compare thousands of different investments over time. In the aptly named "Backtest Portfolio Asset Allocation" page, you can select investments and different parameters to look back at investments over time, as you can see below.
For index based investors, this tool is incredible because it enables you to reference any asset class that you might want to invest in. There's also a page for comparing ETFs or stocks to one another, but I prefer to use the asset class page because it's simpler.
They have also a broad range of existing model portfolios that can be compared against any portfolio that you create. Of course, there's detail info and backtested performance at the bottom of the page once you select everything.
How do I put this all to use? I test and test and test. What's the easiest way for me to expose myself to the most potential upside while limiting my potential downside. It also adds important context to the suggestions that Personal Capital makes. You'll notice that I am way overweight emerging markets and international stocks, and way underweight US stocks. This is because I've used Portfolio Visualizer to see that US stocks have been on a crazy bull run for 10 years, and emerging market stocks... haven't. I try to buy low as much as I can, and that was one opportunity that I saw and took advantage of. My point is that you should use Personal Capital, but inform yourself with other tools as well.
Are you ready to diversify the easy easy way?
It's actually incredible that either of these tools exist. Ten years ago, no one except professional wealth managers had access to backtesting tools this robust. You can even run Monte Carlo simulations with both Personal Capital and Portfolio Visualizer. If you're anything like me and you enjoy investing and planning, then it's a little like a new toy store opened with no pricing. Have fun, get diversified, and stick to your plan once you make it.