In my experience, nearly every investor knows that having a diversified portfolio is something they should do. Diversification, investors understand, helps reduce risk. But there is less knowledge around what diversification actually means. I’ve heard investors say their portfolio was diversified because they had purchased several different tech stocks, or because they worked with multiple advisors or even because they had investments in multiple accounts. In reality, a portfolio is diversified if it is comprised of assets whose prices don’t move in concert in reaction to an event.

If you think through that simple definition and begin listing events that can impact asset prices, you begin to get a sense of what is required for your portfolio to be diversified. Obviously, having just a single stock provides no diversification. Stocks in the same sector – tech stocks, for example – are problematic, too, as they tend to react similarly to events. The same is true for stocks of the same asset class, like small cap U.S. stocks and stocks from the same country. A diversified portfolio of stocks should include both domestic and global companies whose stocks are spread across a number of industry sectors and asset classes.

Beyond stocks, bonds are a key component of a diversified portfolio as they often respond very differently to events than do stocks. For example, in the the last market downturn in 2008, the S&P 500 dropped by nearly 38% but the U.S. bond market was up over 5%. Demand for bonds skyrocketed as investors abandoned stocks, and this is a pattern we often see in market crashes. Having said that, not all bonds performed equally well as there are many, many different types of bonds. Thus, diversification can be helpful within bonds too, and not just among stocks and bonds.

Two key questions when it comes to constructing a diversified portfolio are which asset classes to use and in what proportions. One challenge in picking asset classes is determining which asset classes actually add diversification to a portfolio because they react differently to events than other asset classes being used. Do mid-cap U.S. stocks, for example, behave all that differently than large cap or small cap stocks? Cost of owning the asset class and ease and expense of selling are important factors, too. Wall Street is adept at developing seemingly new types of investments in response to whatever the investor concern du jour is, but most don’t meet all of the criteria above.

Once investments have been selected, the next step is to determine how much of each investment to buy. A financial plan should include a target return, and that figure is a key guidepost in building portfolio. Once that is done, Modern Portfolio Theory tells us that for any given level of return, it is mathematically possible to choose a mix of assets that minimizes risk 1. The problem with this approach is that the correct answer from a mathematical perspective isn’t always practical. The optimal mathematical answer might include 30% in emerging market stocks and 20% in commodities, but few investors would feel comfortable with a portfolio along those lines. Thus, when it comes to portfolio optimization, the first step is to determine what is mathematically optimal and then consider whether or not what is mathematically optimal works in practice.

  1. Risk here is defined as standard deviation of the portfolio. One of the criticisms of Modern Portfolio Theory is that its treatment of risk is overly simplistic and doesn’t measure the real concerns of investors. Howard Marks’ book The Most Important Thing has a great discussion of his for investors.