How to build a diversified portfolio in 6 steps

How to build a diversified portfolio

Building a diversified portfolio requires a clear plan that aligns with your financial goals and risk tolerance. The following steps provide a structured approach to achieving that:

1. Set clear investment goals and assess risk tolerance

Effective diversification begins with understanding your financial objectives. Define whether you are investing for long-term growth, short-term income, or a combination of both. Your risk tolerance also plays a critical role, determining how much exposure you should have to high-risk assets like equities or alternative investments.

For example, a younger investor with a long investment horizon might focus on growth-oriented stocks, while a retiree may prioritise stable income from bonds and dividend-paying equities.

2. Allocate assets across asset classes

Asset allocation is the foundation of diversification. Spread your investments across multiple asset classes, such as stocks, bonds, real estate, and commodities. A traditional 60/40 allocation (60% stocks, 40% bonds) can be a good starting point for balanced investors, though adjustments may be needed based on individual preferences.

For instance, risk-averse investors might increase their bond allocation, while those who are after higher returns could add exposure to alternative investments like REITs.

3. Diversify within asset classes

Adding variety within each asset class reduces the risks associated with over-concentration. In equities, this means investing in different sectors, industries, and geographic regions. For bonds, diversifying by issuer type (government vs. corporate) and maturity length provides better protection against interest rate changes or credit risks.

A well-rounded stock portfolio might include technology, healthcare, and consumer goods sectors, while a diversified bond portfolio could combine short-term government securities and long-term corporate bonds.

4. Include geographic diversification

Economic conditions differ across countries, making geographic diversification an essential part of a robust strategy. Domestic investments often feel familiar but may expose portfolios to risks tied to a single economy. Adding international assets reduces this reliance and broadens growth opportunities.

For example, combining US equities with European and Asian markets allows investors to benefit from diverse growth cycles and reduce the impact of regional economic downturns.

5. Rebalance periodically

Market performance can change asset allocations over time, leaving portfolios misaligned with their original goals. Periodic rebalancing ensures that your portfolio remains diversified and continues to reflect your desired risk profile.

For instance, a strong rally in equities might leave a portfolio overweight in stocks, increasing risk exposure. Rebalancing would involve trimming some equity positions and reallocating funds to underweighted assets like bonds or real estate.

6. Monitor costs and liquidity

Managing expenses is an often overlooked component of diversification. Transaction fees, fund management charges, and other costs can erode returns. Make sure that your portfolio includes a mix of liquid and long-term assets to maintain flexibility without sacrificing performance.

Examples of diversified portfolios

A well-diversified portfolio adapts to the investor's risk tolerance, financial goals, and time horizon. Below are examples of how investors can structure their portfolios based on varying levels of risk:

Conservative portfolio

Conservative investors prioritise stability and capital preservation, often focusing on low-risk investments. This type of portfolio emphasises bonds and other fixed-income securities while limiting exposure to equities and alternatives.

Allocation example:

• 20% stocks: Primarily blue-chip or dividend-paying equities for modest growth.
• 60% bonds: A mix of government and high-quality corporate bonds with varying maturities.
• 10% real estate: Investments through REITs or stable property funds.
• 10% cash: Maintained for liquidity and short-term needs.

Such a portfolio provides steady income and minimises the impact of market volatility, making it suitable for retirees or conservative investors.

Balanced portfolio

Balanced portfolios aim for a mix of growth and stability, appealing to investors with moderate risk tolerance. These portfolios evenly split investments between equities and fixed income while introducing other asset classes for diversification.

Allocation example:

• 40% stocks: Diversified across sectors like healthcare, technology, and consumer goods.
• 40% bonds: A combination of government and corporate bonds, including medium-term maturities.
• 10% real estate: Accessed through REITs or direct investment.
• 10% commodities: Examples include gold or agricultural ETFs.

Balanced portfolios offer growth potential while reducing downside risk, making them ideal for investors with long-term horizons.

Aggressive portfolio

Aggressive investors focus on maximising returns, accepting higher risk in exchange for greater growth potential. This portfolio emphasises equities and alternative investments while limiting bonds and cash allocations.

Allocation example:

• 70% stocks: Includes small-cap and growth-oriented equities alongside international markets.
• 20% alternative investments: Exposure to hedge funds, private equity, or the like.
• 5% bonds: High-yield corporate bonds for income generation.
• 5% commodities: Focus on volatile assets like oil or metals.

This approach suits younger investors with extended time horizons and a tolerance for significant market changes.

Conclusion: Diversification supports portfolio resilience

A diversified portfolio reduces the risks associated with relying on a single asset, sector, or region since losses in one area are balanced by gains in others, promoting stability and consistent performance over time. This is not about avoiding risk entirely but managing it effectively to align with your own financial goals.

By following the steps presented in this guide, you can build a foundation that supports your long-term growth while safeguarding your investments against uncertain market conditions.