How to Build a Diversified Portfolio That Beats the Market in 5 Easy Steps

If you are an investor, you have probably heard the advice to diversify your portfolio. But what does that mean exactly? And how can you do it effectively?

Diversifying your portfolio means investing in a variety of assets that have different characteristics, such as risk, return, and correlation. This way, you can reduce your exposure to any single asset or market, and increase your chances of achieving your financial goals.

Portfolio diversification is one of the most important concepts in investing, as it can help you avoid losing money, enhance your returns, and cope with market volatility. In fact, studies have shown that diversification can explain up to 90% of a portfolio's performance.

But how can you create a diversified portfolio that beats the market? It's not as hard as you might think. In this article, we will show you how to do it in 5 easy steps. Whether you are a beginner or an intermediate investor, you will find this guide useful and practical. Let's get started!

Step 1: Determine your risk tolerance and investment objectives

The first step to building a diversified portfolio is to know yourself as an investor. What are your risk tolerance and investment objectives? How much money do you have to invest, and for how long? What are you investing for, and what are your expectations?

Your risk tolerance is the degree of uncertainty or volatility that you are willing to accept in your portfolio. It depends on your personality, age, income, and financial situation. Generally, the higher your risk tolerance, the more aggressive your portfolio can be, and the higher your potential returns (and losses).

Your investment objectives are the specific goals that you want to achieve with your portfolio. They can be short-term or long-term, and they can vary depending on your needs and preferences. For example, you may want to save for retirement, buy a house, or fund your child's education.

Knowing your risk tolerance and investment objectives will help you choose the right asset allocation for your portfolio. Asset allocation is the process of dividing your portfolio among different asset classes, such as stocks, bonds, cash, and alternatives. Each asset class has its own risk and return profile, and they tend to behave differently in different market conditions.

Step 2: Choose an asset allocation strategy that suits your profile

The next step to building a diversified portfolio is to choose an asset allocation strategy that suits your profile. There are many ways to do this, but here are some of the most common ones:

• The rule of thumb: This is a simple and popular method that uses your age as a guide to determine your asset allocation. The idea is to subtract your age from 100, and use the result as the percentage of your portfolio that should be invested in stocks. The rest should be invested in bonds and cash. For example, if you are 30 years old, you should have 70% of your portfolio in stocks, and 30% in bonds and cash. This method assumes that you should reduce your exposure to stocks as you get older, and increase your exposure to less risky assets.

• The risk-based approach: This is a more sophisticated and customized method that uses your risk tolerance as the main factor to determine your asset allocation. The idea is to use a questionnaire or a tool to assess your risk tolerance, and then use the result to choose a portfolio that matches your risk profile. For example, if you have a high risk tolerance, you may choose a portfolio that has 80% in stocks, 15% in bonds, and 5% in cash. This method allows you to tailor your portfolio to your personal preferences and goals.

• The goal-based approach: This is another customized method that uses your investment objectives as the main factor to determine your asset allocation. The idea is to identify your specific goals, and then use a calculator or a tool to estimate how much money you need to save, how long you have to save, and what rate of return you need to achieve your goals. Then, you can choose a portfolio that has the appropriate level of risk and return for your goals. For example, if you want to save $100,000 for a down payment in 10 years, and you need a 7% annual return, you may choose a portfolio that has 60% in stocks, 35% in bonds, and 5% in cash. This method allows you to align your portfolio with your desired outcomes.

No matter which method you choose, you should remember that your asset allocation is not set in stone. You should review and adjust it periodically, depending on your changing circumstances, market conditions, and portfolio performance.

Step 3: Select the best investments for each asset class

The third step to building a diversified portfolio is to select the best investments for each asset class. This is where you can get creative and have some fun, as there are many options to choose from. Here are some of the most common ones:

• Stocks: Stocks are shares of ownership in a company. They can offer high returns, but they also come with high risks and volatility. When choosing stocks, you should consider factors such as the company's financial performance, growth potential, competitive advantage, valuation, dividend yield, and industry trends. You should also diversify your stock portfolio across different sectors, regions, and market capitalizations, to reduce your exposure to any single stock or market.

• Bonds: Bonds are loans that you make to a government or a corporation. They can offer steady income and lower risks, but they also come with lower returns and interest rate risk. When choosing bonds, you should consider factors such as the issuer's credit quality, maturity date, coupon rate, yield to maturity, and price. You should also diversify your bond portfolio across different types, durations, and ratings, to reduce your exposure to any single bond or issuer.

• Cash: Cash is money that you keep in a bank account, a money market fund, or a certificate of deposit. It can offer liquidity and safety, but it also comes with low returns and inflation risk. When choosing cash, you should consider factors such as the interest rate, the fees, the accessibility, and the insurance. You should also keep enough cash to cover your emergency fund and your short-term needs, but not too much that it hurts your long-term returns.

• Alternatives: Alternatives are investments that do not fall into the traditional categories of stocks, bonds, and cash. They can offer diversification and higher returns, but they also come with higher risks, fees, and complexity. Some examples of alternatives are real estate, commodities, hedge funds, private equity, and cryptocurrencies. When choosing alternatives, you should consider factors such as the expected return, the risk, the correlation, the liquidity, and the transparency. You should also limit your exposure to alternatives to a small portion of your portfolio, as they are not suitable for everyone.

When selecting the best investments for each asset class, you should also consider the costs and taxes involved. You should look for investments that have low fees, commissions, and expenses, as they can eat into your returns. You should also look for investments that have favorable tax treatment, such as tax-deferred or tax-exempt accounts, as they can boost your after-tax returns.

Step 4: Rebalance your portfolio regularly

The fourth step to building a diversified portfolio is to rebalance your portfolio regularly. Rebalancing is the process of adjusting your portfolio to maintain your desired asset allocation. It involves selling some of the assets that have increased in value, and buying some of the assets that have decreased in value.

Rebalancing is important because it can help you reduce your risk, enhance your returns, and stay on track with your goals. Without rebalancing, your portfolio may drift away from your original asset allocation, and become more exposed to market fluctuations and underperformance.

There is no definitive rule on how often you should rebalance your portfolio, but a common practice is to do it once a year, or whenever your portfolio deviates from your target asset allocation by more than a certain percentage (e.g. 5% or 10%). You should also consider the costs and taxes involved in rebalancing, and try to minimize them as much as possible.

Step 5: Monitor your portfolio performance and make adjustments as needed

The fifth and final step to building a diversified portfolio is to monitor your portfolio performance and make adjustments as needed. Monitoring your portfolio performance means tracking how your portfolio is doing in terms of risk, return, and progress towards your goals. You can use tools such as statements, reports, charts, and benchmarks to measure and compare your portfolio performance.

Making adjustments as needed means making changes to your portfolio based on your changing circumstances, market conditions, and portfolio performance. You may need to make adjustments to your portfolio if:

• Your risk tolerance or investment objectives change

• Your portfolio underperforms or overperforms your expectations

• Your portfolio becomes too risky or too conservative for your profile

• Your portfolio experiences a significant gain or loss

• Your portfolio faces a major market event or crisis

When making adjustments to your portfolio, you should be careful not to overreact or underreact to the market movements or your emotions. You should also be consistent with your asset allocation strategy and your rebalancing schedule, and avoid making frequent or drastic changes to your portfolio.

Conclusion

Diversifying your portfolio is one of the best ways to improve your investing results and achieve your financial goals. By following the 5 steps outlined in this article, you can build a diversified portfolio that beats the market in any situation.