How to “Build” a Diversified Portfolio
I believe it is important to have a diversified portfolio, but not in the usual manner that is recommended by many financial advisors. I do not believe multiple asset classes are effective in helping investors attain their long-term financial security which, when all is said and done, is the objective of investing. I prefer investments in the major asset classes of stocks and fixed income that provide steady cash flow.
Stocks can be well diversified by an investment in the major index funds. Fixed income can be handled with insured bank certificates of deposit and individual bonds.
The stock, or equity portion of your portfolio, can be apportioned over the major index funds such as the DJIA, S&P 500 and Russell 2000. This provides broad stock market coverage and diversification as well as foreign exposure since about 40% of the revenues of the S&P 500 companies are out of the United States.
CDs are quite satisfactory for up to five years, and especially if they are somewhat laddered to grab a little higher yield. If you stay under the insured limits, your funds are fully secured. Going beyond five years becomes harder since I recommend individual bonds. I’ve written a few blogs on how to do this, but to repeat about diversification, I would not put more than 10% of your fixed income allocation into any one company or more than 20% into any one sector. A good bond broker can help you select the bonds or if you are more of a do-it-yourselfer you can search the inventory of many of the on-line brokerage firms. My most recent bond blog is here.
Right now you can put together a stock portfolio paying about a 2% dividend with potential capital gains growth; while you can construct a fixed income portfolio paying about 3%. This has to be balanced against your eventual cash flow needs keeping in mind that inflation will erode future spending ability.
There are other issues such as the allocation between equities and fixed income; determining the amount of cash flow you need; your current and future saving and spending behavior; the timing of when income and principal withdrawals will start and where they will come from; whether and when re-balancing should be considered; and the actual selection of the indexes or whether you prefer actively managed mutual funds; whether you will engage an investment manager; how all of this fits into your long-term goals; your emotional involvement or detachment; and a caution to not assume a greater risk than you need to accomplish your goals.
Investing is certainly confusing and difficult and because of this, many abdicate the decision making process looking for someone that will provide a quick fix. I believe my recommendations are easy to understand and follow if a little bit of focused effort is made. You are dealing with the responsibility for you and your family’s ultimate financial security and I think that should have some energy and active involvement by you. Further, my ultimate rule of never investing in anything that you do not fully understand can be easily put to use in this process and by using my blogs as guidance and as a resource.
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