A diversified portfolio is essential for success of all investors. Think of all the most successful hedge fund managers like Bill Ackman, David Tepper, Paul Tudor Jones, and Ray Dalio have in common? What about other successful investors like Warren Buffet, Steve Schwarzman, and Robert Smith?
While each of these investors use a different stock market investment strategy, one thing they have in common is that they all have diversified portfolios. None of them have made their fortune by investing in one company. This article will look at what is a diversified portfolio, the diversified portfolio theory, and how to invest in a diversified portfolio investment.
What is a Diversified Portfolio?
A portfolio is a group of assets that are created by investors with the goal of maximizing returns. In simpler terms, a diversified portfolio is not having all your eggs on one basket. A single portfolio can be made up of stocks, ETFs, bonds, indices, commodities such as oil and gold, and mutual funds.
In developing a diversified portfolio, investors look at the potential of each investment. A good example of a diversified portfolio is that of Warren Buffet, which is made up of companies like Amazon, Wells Fargo, Kraft Heinz, Apple, and American Express.
Types of Diversified Portfolios
Some investors believe that the best way to make more money in the market is to buy and hold a handful of companies. A good example of such an investor is Bill Ackman, who manages more than $8 billion in assets. For more than 20 years, the investor has invested in just a handful of companies. The disadvantage of this is that a single mistake can have major implications for the entire portfolio. Bill Ackman learnt this the wrong way when he lost more than $4.4 billion when his investment in Valeant Pharmaceuticals declined.
This is the opposite of a concentrated portfolio. In this, the investors believe that the best way to make money is by buying tens or hundreds of stocks. A good example of such a portfolio is that being managed by Warren Buffet, which has more than 50 companies.
Some investors believe in creating a portfolio that is diversified in the same industry. For example, a technology investor can create a portfolio with technology companies like Google, Facebook, and Twilio. Others believe in creating portfolios that are diversified across the industries. For example, they invest in technology, materials, real estate, and consumer goods industries. We can say that Warren Buffet has a multi-sector portfolio because his investments are in several sectors.
Asset Class Portfolio
Many investors believe in investing in a singular asset class. A diversified portfolio of stocks is made up of stocks only. This is the model that is used by many investors. Others believe in having a multi-sectoral portfolio. In this, they create a portfolio with assets like stocks, bonds, and commodities. A good example of such investors is Ray Dalio, who runs the biggest hedge fund in the world. The portfolio is made up of stocks and ETFs.
Some investors believe in investing in a single market. Warren Buffet is a good example of such investors. Others like Ray Dalio believe in buying assets from more than one country or region.
Some investors believe in having a diversified portfolio of large-cap value companies like Proctor & Gamble, Unilever, and AT&T. Others believe in having a mixed portfolio that combines small caps, mid-caps, growth companies, and dividend companies.
Benefits of a Diversified Portfolio
There are four primary reasons why diversification is a good thing in portfolio management. These are:
- Minimizing risks. Recently, Sears Holdings filed for bankruptcy. This led to significant losses for people who had placed all their bets on the company. However, those who owned Sears and other companies like Amazon, Google, and Shopify were largely unscathed.
- Preserving capital. When you own a diversified portfolio of companies and other assets, you preserve your capital while reducing risks.
- A good way for newbies. If you don’t have a lot of experience in the market, you can invest in the already-created portfolios like indices, mutual funds, and ETFs.
- Peace of mind. When you own multiple assets, you have a peace of mind especially when one company in the portfolio declines.
Exchange Traded Funds
A good way of investing in a diversified portfolio is through an Exchange Traded Fund (ETF). An ETF is a financial asset that is created by large institutions like Vanguard and Blackrock. When creating the ETF, these companies buy a group of stocks, and then list them in an exchange. Investors then buy the listed price of the ETF. A good diversified stock portfolio example is the Consumer Discretionary Select Sector SPDR ETF that was developed by State Street. The ETF is made up of 65 large companies in the consumer discretionary sector. Some of these companies are Amazon, Home Depot, Starbucks, and Nike.
There are two primary ways you can diversify when investing in ETFs. First, you can buy just one ETF that you believe will do well. For example, when you invest in the QQQ ETF, you have basically invested in all companies in the S&P 500 index.
Alternatively, you can create a portfolio of several ETFs. An example of a diversified ETF portfolio is when you invest in the following:
- Vanguard Consumer Staples ETF (VDC)
- Vanguard Financial ETF (VFH)
- Vanguard Dividend Appreciation ETF (VIG)
- Schwab U.S. Mid-Cap ETF (SCHM)
- Materials Select Sector SPDR ETF (XLB) If you buy all these ETFs, you will have created a diversified ETF portfolio.
Summary on Portfolio
The financial market is a risky place. One way of reducing this risk is by creating a diversified portfolio. While there are complex procedures of portfolio creation, you should just do your research on a number of companies and bonds and invest in them. Alternatively, you should invest in ETFs, mutual funds, and index funds, which are diversified portfolios.
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Kasper is our expert for saving, investing and bank accounts. Kasper holds an MSc in Mathematics and worked with Mercedes-Benz and the Dutch tax authorities.