Portfolio Selection and Diversification: Building a Truly Diversified Portfolio

Do You Think You Are Well Diversified? Better to Think Twice

Having a portfolio that supports your investing goals is a key thing in order to be a successful investor.

There is a ton of strategy to build a stock market portfolio and I am sure that you noticed that everyone of them has some degree of diversification.

Diversification is actually a mantra in the world of investments and there are good reasons for that.

Long story short: portfolio diversification allows you to reduce the overall risk of the portfolio

In this way it is possible to achieve a higher return for every unit of risk. 
It makes a lot of sense because having all your investments in a single stock is too risky, of course.

portfolio-returns

However, that might be only part of the story. Let me ask you this:

  • Is diversification really that good for your investments?
  • What does it mean to have a real diversification?
  • Are you truly diversified with your portfolio?

These are the king of questions that can really enhance our investing portfolio.

Let’s dig into it.




The Perfect Portfolio

The perfect investing portfolio is the one that allows you to achieve your investing goals no matter what happens in the markets.

A portfolio that allows to have satisfying returns (what is satisfying depends on you, your situation and your goals) no matter the situation of the economy and financial markets.

If you have been investing in the last decade, it has been a really good period overall since we saw only growth after the 2008 crisis and the following recession.

We are currently in the second longest economic expansion in history, it is going on for 9 years and it might soon become the longest ever.

Overall things seem to be doing great: growing economy, rising stock market, unemployments at record lows and low interest rates.

However, this has a price represented by incredibly high levels of debt, increased fragility in the system, less tools to stimulate the economy in case of a crisis and a high chance of seeing a recession in the next few years.

The situation didn’t really imporoved a lot since 2008.

How your portfolio would be affected if the economy and the market were to go the opposite way?

Would you be able to still achieve your investing goals and target returns if a recession shows up?


Building an ACTUALLY Diversified Portfolio

When talking about diversification many think about and index, like the S&P 500, or investing into an ETF.

Well, while investing into an index can give you some sort of diversification, it is far away from the concept of overall portfolio diversification.

While you hear about diversification all over the place when looking for investing strategies and how to perform a portfolio capital allocation, very few investors are truly diversified.

Real diversification is not investing in the S&P 500!

If things go bad in corporate America and you are invested in the index “in order to be diversified”, you see the value of your investments deteriorate. Period.

There is little you can do because you are not that diversified, indeed you are really concentrated on corporate America.

Real diversification is achieved by balancing:

  • Different Asset Classes
  • Various types of Securities
  • Uncorrelated Financial Assets
  • Geographical Exposure
  • Currency Exposure
  • Exposure to Change in Technology
  • Protections and Hedges
  • Alternative Investments

This is just a short and non-exhaustive list to provide an idea of what should be included into a real diversification strategy. You can add every other factor that you can think of. 

The point here is that in order to be diversified, one should be invested in different asset classes that have different exposure to many important factors, like geographical, currency, and sector growth exposure.

Diversification and Portfolio Hedges

One of the advantages of having a truly diversified portfolio is the inclusion of protections and hedges.

Having appropriate hedges it something that is often overlooked, but it is another key that can protect your investments.

Anything can happen in the market. Portfolio hedging is the application of a variety of techniques to reduce the overall risk exposure.

The aim of hedges is to minimize the negative impact of adverse market movements, price swings and negative shocks on the investments.

Hedges allow to reduce losses and could even counterbalance negative returns on your core portfolio

Common techniques are the use of derivatives, like futures and options, and investments in uncorrelated asset classes.

One interesting things about hedges it that they are usually really cheap when there is a lot of value in them. Like options: when there is low volatility no one expects a significantly higher volatility in the future and option prices are consequently low.

Let’s see an example with gold.

Gold as a Hedge in Your Portfolio

Gold has always been a safe haven asset and during the last decade it is becoming more and more important due to central banks behavior.

Given the current financial environment with ultra-expansive monetary policy, it is likely that during the next downturn we will see a large use of monetary policy in the attempt of stimulating the economy.

Even right now, that we are towards the end of the cycle but still in the economic expansion phase, central banks are already talking about slowing down on interest rates hikes in order to keep the economy going.

This should not come as a surprise, since if they were to raise interest rates they would crash the market. But that’s another story.

Gold, in this picture, becomes increasingly important because, besides being a safe-haven asset and a store of value by itself, it can’t be inflated by central banks monetary policy.

Even a small amount of gold in your portfolio can be a great hedge against a market crash. Look at what happened after 2008:

gold-price-chart
Gold Fixing Price, 2000–2019. Source: FRED

Since the throat in October 2008, at $728.5/ounce, during the financial crisis and the first part of the recession, gold rose to reach a maximum of $1,826/ounce in August 2011. 

In other words, the price of gold rose 151% in 3 years. It just makes sense to have a certain amount of gold in your portfolio.

During the same period, a massive manipulation of the entire economy went on through the expansion of the monetary base.

This was an extraordinary measure no one seriously considered before 2008, but it is real and happened in the economy.

Currency Creation by Central Banks — Source: FRED

The quantity of currency almost quintupled in a matter of a single decade and this was all currency created in order to keep the economy going.

This is something that you can really expect to see another time when a crisis will hit the economy, a thing that could happen very soon.

Gold is an insurance against monetary policy and economic recession

It should not come as a surprise that even central banks are hoarding gold as a reserve currency. It certainly holds its value better than the dollar.

What About Your Portfolio?

Building a great portfolio is something that takes some years and a lot of research. 

It is definitely something that you don’t do overnight. 

But remember, we naturally tend to overestimate what we can do in one year and really underestimate what we can achieve in some years or over the course of a lifetime.

I hope that this article gave you some useful suggestions to build a better investing portfolio that points directly towards your investing goals.

A few questions to think about:

  • What is your degree of real diversification?
  • Do you have any hedge in your portfolio?
  • Do you know how your portfolio would be affected by a recession?
  • Do you already know what you are going to do?

Think about them and let me know by leaving a comment.

Answering those question is a starting point to improve your investments over the long-term. Your future self will certainly thank you.


This article is for informational purposes only, it should not be considered financial advice. You can read the full disclaimer here.

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