Well Diversified Portfolio: The Ultimate Step-by-Step Guide

well diversified portfolioWhen you invest in the stock market, are you gambling with your money?

A growing number of people say stock market is rigged.

Only the rich and large corporations can use it to get ahead.

But that’s overused hogwash.

The stock market has provided us with a long history of high returns.

The secret is discovering how to capture those returns with a well diversified portfolio.

And today’s your lucky day. I’m going to show you the exact, step-by-step method I use to check whether my stock portfolio has a good mix of investments.

Once you’re done with this article, you’ll know exactly how to analyze any investments and determine within minutes whether they’re a well diversified portfolio.

Are you ready?

How Diversification Can Save You From Major Losses

Look:

Wall Street and the media like to fill our minds with their marketing nonsense.

They try their best to make you think that diversification is only for “unsophisticated investors”.

Well, if “unsophisticated” means – “Loves great long term returns”… then yes… I’m an unsophisticated investor.

They want you to believe that it’s easy to predict the future.

Here’s the problem:

Nobody can do it.

If they could, then I would only need one mutual fund. I’d invest in that one magical fund, and all my problems would disappear. It would give me the best returns year after year.

But check this out:

The S&P Dow Jones did a 2014 research study on all funds that performed in the top quartile in 2010. These were the funds that not only beat the market, but beat it good! The study started with 706 mutual funds that had this honor.

They tracked their performance over the next 5 years to see how many of the 706 continued to perform well.

Here’s the results:

S&P Dow Jones Study

Let’s break it down:

In 2010 they started with 706 big winners.

How many of those continued to perform well over 5 years?

2011: 266
2012: 73
2013: 33
2014: 9

Only 9 of the original 706 mutual funds consistently performed well over 5 years.

Think about this:

The study only tracked 5 years. By looking at these drastic results, I can’t imagine these 9 will continue to succeed over the next few decades.

That means that every few years, you’ll need to successfully choose one of the few funds that will outperform the many.Capture

You know what it sounds like: Gambling

Investing in the stock market is gambling, if you do it this way.

But I don’t gamble with my money.

I use a well diversified portfolio.

 

What Constitutes a Well Diversified Portfolio?

I explained exactly what constitutes a well diversified portfolio in my previous post – Diversification is Important in Investing for 5 Simple Reasons.

Let’s review the main points:

Diversification simply means to investing in areas of the market that move in different directions.

When one area zigs… the other zags.

By using a well diversified portfolio, it helps you reduce the risk you take in these important areas:

Company Risk

EnronInvesting in single companies brings added risk with it.

But here’s the truth:

You don’t get paid any additional return for taking this risk.

Rather than investing in a single company, it’s important to spread your money around in that entire industry.

Industry Risk

But investing in one industry doesn’t work either.

Just ask how Tech stock investors liked their returns in the early 2000s when the tech bubble burst.

But a diversified portfolio didn’t drop nearly as much during that time period.

It’s important to invest in the entire stock market – across all industries.

Market Risk

falling stock marketHere’s a no brainer:

You can lose money in the stock market.

But you  can help alleviate this risk by investing in bonds.

Inflation Risk

Here’s the problem with bonds:

Their return is horrible.

If too much of your portfolio in bonds, then it’ll get drained by rising prices over the years.

You need to have a good mix of both stocks and bonds.

Stocks are used for return (and inflation protection) and bonds are used for safety.

Country Risk

The United States has had a great run when it comes to stocks.

But that’s not a guarantee that it will continue.

And check this out:

We’ve had times when International have handily beaten U.S.

For example: International blasted by U.S. during most of the “Lost Decade”… beating U.S. six years in a row.U.S. Vs Foreign During Lost Decade

These things run in cycles.

Reduce your risk by holding some International investments.

Learn More About Diversification

You can find more details about the above sections by checking out my previous article.

 

Give Your Personal Investment Portfolio a Checkup

Let’s get started:

If you’re not well diversified in the stock market, then you’re not investing in the market the right way.

It’s time to give your portfolio a checkup.

The best tool I’ve found to get the job done is the TD Ameritrade Xray Tool. It gives you some of the premium features of Morningstar’s XRay tool for free.

TD Ameritrade X-Ray

I’ll walk you step-by-step in using this tool to check your investments.

The first step is to enter your investments.

You can enter either tickers or the names.

TD Ameritrade X-Ray Tool

For this example, I’m going to be using a 100% stock portfolio featuring these two ETFs:

VTI – Vanguard Total Stock Market

VXUS – Total International Stock ETF

Note: This is not a recommendation of these funds or this portfolio. They are simply provided as a sample portfolio.

-Add the amounts next to each investment. You can enter these as either dollar amounts or percentages.

If you need more lines than what is provided, you can click the “Add more rows” link at the bottom.

Click next to get started with your portfolio checkup.

 

1) Are You Well Diversified Between Different Companies?

Let’s check to see if you’re well diversified between companies.

Stock Intersection

Click the stock intersection tab.

The stock intersection tool will display the top 50 stocks in your portfolio, along with what percentage you hold of each.

Company Diversification

Also, it will display which funds invest in the stock. If multiple funds invest in a specific stock, each will be listed together.

We’re interested in analyzing the top 10 companies – found on page 1.

Add up the bold numbers in the “% of investments” column. The total in the example is 10.37%.

This tells me that 10.37% of my money is in just 10 stocks.

This isn’t very diversified.

My personal target is to hold less than 4% in the top 10 stocks.

In general, the lower this number- the better.

Do you have multiple funds that seem to hold significant amounts of the same company?

If so, it might be wise to get rid of all but one of them.

There’s no sense in owning overlapping funds that hold the same stock.

 

2) Do You Own Enough of Each Industry?

Next, let’s check that you’re diversified across different industries.

Select Portfolio

Click portfolio X-Ray to go back to the original screen.

Scroll down to the “Stock Sectors” section:

xray 5

The main goal here is to make sure you have a good spread across the different industries.

The blue “portfolio” bar is what you need to analyze.

In the example, we have a good spread between the different industries.

What you don’t want to see is one area dominating or other areas with no representation.

If you think you have a problem:

Check to see if you own any “sector funds”. These will usually have the sector in their name such as:

XYZ Energy Fund

ABC Utilities Fund

These funds will need to removed if you want a well diversified portfolio.

3) Are You Well Spread Out in the Different Areas of the Market?

Next, we’re going to check how diversified we are across different areas of the market.

More specifically – the difference between our large and small companies.

– On the same page, scroll down to stock style:

Company Size

Add up the top row.. which represents the percentage of large companies.

And add up the bottom row.. the small companies.

In the portfolio example, we have 74% in large and 8% in small.

This isn’t very well diversified.

Try adding more small cap index funds to your portfolio.

4) How Well is your International Diversification?

Look:

International is important.

But investors often neglect it.

Scroll back up to the top and check your U.S. Stocks Vs. Non-U.S. Stocks under “Asset Allocation”.

Country DiversificationIn our example portfolio, we have 74% in U.S. and 24% in Non-U.S.

Many advisors would say that this is plenty – but I’m here to teach you the right way to invest.

The U.S. only makes up 40% of the global market, so investing 74% in it doesn’t make much sense.

I invest in a 50/50 split between U.S. and International.

But if you’re not comfortable with that, strive to invest in 60% U.S. / 40% International.

Neglecting International will hurt you in years when U.S. does nothing.

[yellowbox]Extra Credit: While you’re here, check how much is invested in Cash. If you have more than about 4% in cash, there’s a good chance that at least one of your investments is gambling with your money. [/yellowbox]

5) Do You Have a Good Stocks Vs Bonds Mix?

Also in the “Asset Allocation” section, you can see the amount of bonds.

In our example, I didn’t add any bonds.

100% in stocks is an acceptable allocation if you more than 10 years to invest before retirement.

As you get closer, add more bonds to your portfolio.

The important thing is this:

Make sure that the amount of bonds is something that is well balanced.

If you have too much in stocks at the wrong time (close to retirement), then you run the risk of losing money when you need it.

If you have too much in bonds, then you run the risk of losing money to inflation.

In Review: Do You Have a Well Diversified Portfolio?

How does your personal investments stack up?

Did you find any issues?

Here’s a review of some of the things to look for in the TD Ameritrade Xray:

  • What percentage do you hold of the top 10 stocks? Try to keep it under 4%.
  • Are you invested in each sector? Make sure you don’t hold any sector funds.
  • Do you have a good mix between small and large companies? The average investor sacrifices return because they invest too much in large companies.
  • Don’t neglect International diversification. If you’re not comfortable with a 50/50 split, go with 60/40.
  • How’s your Stocks Vs. Bonds? Ensure that they lineup with your long-term goals.

When you’re using a well diversified portfolio, you’re not gambling with money.

You’re ready to capture the market’s long-term returns.

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Comment List

  • Chris Gagner April 22, 2015
    Reply

    I’m glad I`m not the only one investing a lot in imternational right now. My friends look at me like I am crazy.

    • Chris Gagner April 22, 2015
      Reply

      The average investor doesn’t have very good returns. So if your friends think you’re crazy, it’s probably a good thing.

      Keep up the good work!

  • Chris Gagner April 27, 2015
    Reply

    I listen to Dave Ramsey on a regular basis and I’ve read his books. He says that you shouldn’t invest in bonds but rather hold 100% in stocks.

    • Chris Gagner April 27, 2015
      Reply

      Hey Starla,

      I have great respect for Dave Ramsey’s “Get Out of Debt” teachings.. and he’s definitely helped tons of people cut up the credit cards.

      But the research shows that his 100% stocks theory just isn’t smart.

      Even a well diversified stock portfolio would have lost more than 40% in 2008.

      But if you held the right type of bonds that year, they were up 13%- no need to worry about how you’re going to draw a retirement income.

      I would definitely caution you to beware of anybody who tells you to hold 100% stocks in retirement – even if they’re a well known financial guru.