In this article we’ll cover:
- The importance of goal setting
- Understanding the importance of balancing risk and returns
- Why diversification matters
- How to think about your own risk appetite
Buying is only half the battle when it comes to investing. Deciding what assets to buy and which to avoid, as well as the relationship between risk, returns, and volatility, is also key.
But maybe most importantly, is understanding how these factors all work together – as part of a broader, diversified investment portfolio. In this article, we’ll cover 5 tips investors can use when thinking about constructing a diversified portfolio.
1. Goal-setting as a starting point
If you’re looking for a ‘hack’ for how to effectively build a diversified investment portfolio, you’ll quickly discover that there are no quick or simple answers. Some will say that you should hold a varied number of different stocks – anywhere from 10 to 100.
Others might suggest you focus on diversification from an asset level – that is, you build a portfolio made up of different stocks, bonds, alternative assets, and potentially crypto.
Remember: at the end of the day, much of how you construct a diversified portfolio will depend on your own circumstances - something that only you can know, and something that is explicitly not considered as part of this article.
In saying that, a good place to start when thinking about how to construct a diversified portfolio is to clearly define your investment goals. Setting goals will help to motivate you and keep you on track with your investments. Goals can help you to focus on what’s important to you and avoid getting distracted by short-term ups and downs in the market.
When setting goals, think about the reasons why you want to invest. For example, it might be worth considering: Are you saving up to travel or buy a home in a few years? Perhaps a new car? Are you investing simply for peace of mind, or to build wealth over the long-term? Take some time to think about where you are headed and where you want to go.
Beyond thinking in terms of why, putting a timeframe and a realistic dollar-value target on your investment portfolio will also help you decide how much risk you can and indeed, should practically take.
An investor who’s looking to retire in 30 years is likely better placed to benefit from a riskier portfolio – which might look like a portfolio heavily focused on stocks and maybe even some crypto. By comparison, an investor who’s looking to retire in the next 5 years or less will likely want a less risky portfolio. This might look like a portfolio made up mostly of bonds and some stocks. Again, this all depends on your own goals and your own ability to tolerate risk. The important part here is to be honest with yourself.
2. Balancing risks and returns
In the context of constructing a balanced portfolio, understanding the role of risk is important for two key reasons. One, investment performance – that is, how much you expect a stock or another asset to rise or fall – is generally correlated to its risk profile.
In general, more volatile (or risky) assets tend to deliver higher potential returns over time, but with greater variation along the way. By comparison, lower risk assets tend to achieve lower, but more consistent returns over time.
For instance, investments such as shares and cryptocurrencies are relatively volatile. Their values can change rapidly depending on investor sentiment and market conditions – but they can also achieve larger returns over time.
Take electric automaker Tesla for example. Since it became a public company, the stock has risen over 19,000%. If you had invested USD 1,000 at the time of Tesla’s IPO on June 29, 2010 – your shares would be worth around USD 191,000, as of June 27, 2022.
While this example highlights the power of investing in stocks, it only tells half the story. Take another example. If you had instead invested USD 1,000 in Tesla at the start of 2022 – guess how much those shares would be worth today? As of June 27, 2022, they’d be worth about USD 614. This is the kind of volatility that investors should always keep in mind when investing.
In contrast, investments such as government bonds (not to be confused with corporate bonds) are considered lower risk because they pay regular income, generally maintain a relatively stable price, and are backed by the power of the issuing government, like the US Government. Of course, while bonds do fluctuate in value – primarily due to movements in interest rate markets – they are reliably less volatile than stocks. To be sure, while a company might go bankrupt, which would impact its share price, it’s unlikely that the US government will go bankrupt.
The second key reason that understanding the relationship between risk and return is a psychological one. That is, if you take on too much investment risk, you might feel uncomfortable with your decisions and find it difficult to stick to your investment plans over the long, or even the short-term.
3. Managing portfolio risk through diversification
The main tool individual investors have for managing risk and volatility in their portfolios is diversification. Think about diversification like you would a balanced diet: To stay healthy you need protein, vitamins, and minerals, among other things. If you don’t eat a balanced diet, if for example you just ate steak, your health could suffer. The same is true of investing.
While it might be tempting to go ‘all in’ on Tesla – that is, to just eat steak and nothing but – it would be healthier for your portfolio to spread your money across a range of investments. This practice can help to limit losses in times of market volatility. If one investment in your portfolio performs poorly, other investments will be there to support the performance of the overall portfolio. At the end of the day, the aim of diversification is to smooth out overall portfolio returns – over the long-run and in times of elevated market volatility.
How diversification works in practice
A basic form of diversification is to include both shares and bonds in your portfolio. Some, like the legendary investor Benjamin Graham, suggested investors split their portfolio 50/50 between stocks and bonds, and potentially consider adjusting those weighting towards a 75/25 split, based on market conditions.
Of course, much has changed since Mr. Graham made those suggestions in the middle of the 20th century – with the options available to indiviudal investors, through investment platforms such as Syfe – having grown exponentially. It’s also important to keep in mind that shares, bonds, and cryptos all react differently to economic conditions and variables. As a rule of thumb: When bonds decrease in value, shares tend to increase in value. When interest rates go up, technology stocks tend to decline in value. And when tech stocks decline in value, crypto assets also tend to decline.
One way of incorporating these types of assets into a portfolio is to use ETFs, such as the Vanguard Total International Bond ETF (BNDX) for bonds and the SPDR S&P 500 ETF (SPY) Trust for shares. If you’d like to learn more about ETFs, click here to read our in-depth overview of ETF Investing – 4 Key Benefits Explained.
Beyond shares and bonds, as we briefly touched on above, you can obtain further diversification by investing in cryptocurrencies, either directly or through a Fidelity Crypto Industry and Digital Payments (FDIG) ETF, for example; physical property or REITs (real estate investment trusts), and other alternative assets. Besides asset class choices, diversification can also be thought about in terms of geography and sector.
4. Think about your risk appetite
If you haven’t thought much about your appetite for risk, now is the perfect time to start. Consider it this way. If you’re saving for a long-term goal, you may be more willing to take on more risk because you will have more time for your investments to recover, if they were to decline in value. If you do have a long-term focus, you might consider including a larger portion of your portfolio in assets that are higher risk – such as shares or even a small portion in crypto.
If your timeframe is shorter, you might want to focus on assets that are historically more stable – such as bonds or broad-based, exchange traded funds (ETFs), like the S&P 500 example we’ve discussed above.
Of course, everyone is different. A level of investment risk that feels comfortable for one person might not be the same for someone else.
5. Regularly monitor your portfolio
After you’ve put together a portfolio, especially if it’s one composed of higher risk assets like stocks or even ETFs, it’s important you monitor it.
For example, you could consider setting up a regular investment plan using Syfe’s recurring trade feature to add to your portfolio over time. This would involve buying at set intervals – rather than trying to actively pick the right time or price to trade. You might for example choose to buy USD 250 worth of the SPDR S&P 500 ETF Trust (SPY) on the 15th of every month. This is a practice known as dollar-cost averaging, and is an approach known for helping investors to smooth out the impact of volatility over time. As the old investment saying goes, ‘it’s not about timing the market, but about time in the market’.
You should also regularly check the performance of your portfolio to make sure you’re staying on track. How often you review your portfolio will depend to some extent on your investment timeframes. In general, a shorter timeframe will require more frequent reviews, while with a longer timeframe you might be more comfortable adopting a ‘set and forget’ mindset.
This article/webinar is brought to you by Syfe Australia Pty Ltd., CAR number 1295306 of Sanlam Private Wealth Pty Ltd (AFSL 337927). Disclaimer: Investing involves risk including the risk of losing your invested amount. We do not provide personalised advice or recommendations. Any information we provide is general advice and current at the time written. Please speak to your Financial or Tax adviser for personal advice. Any reference to an investment’s past or potential performance is not an indication of any specific outcome or profit. Data in article correct as of June 27, 2022. Article updated 6 April 2023.
