Anyone interested in investing knows the merits of diversification. The goal of diversifying your portfolio is to maximize potential gains while limiting risk. The problem is, with a small amount of money, how do you diversify?
Many advisors suggest indexing as a way to gain diversification. Buying an ETF such as SPY, which tracks the performance of the S&P 500 does indeed allow you to gain access to a breadth of stocks in different sectors without having to buying each one individually. While this isn’t bad advice, you can do better, even with less than $1000. I’ll show you how.
Buying an indexed ETF limits your exposure to any one particular stock. This gives you diversity in stocks, but doesn’t give you the potential upside and risk limiting benefits of other asset classes such as government and corporate bonds, precious metals, commodities, real estate, and foreign markets. With a stock only portfolio, if stocks go up, your portfolio goes up, if they go down, so does your account balance.
By buying different asset classes that are not fully correlated with each other, you can do well in any environment. Let’s take a look at how you can achieve this with less than $1000.
Here’s a sample portfolio:
2 Parts US Stock Market – BTB pick – SPHQ – High Quality S&P500 ETF
1 Part Emerging Markets – BTB pick – EEM – Emerging Markets ETF
1 Part International Developed Markets – BTB pick – SCHF – Aggregate International Developed Markets ETF
2 Parts US Bond Market – BTB pick – PLW – 1-30 Year Maturity US Treasury ETF
1 Part Corporate Bond Market – BTB pick – LWC – Mixed Corporate Bond ETF
1 Part Gold – BTB pick – IAU – Gold Trust ETF
1 Part Commodities – BTB pick – PDBC – Optimum Yield Diversified Commodities ETF
1 Part Real Estate – BTB pick – PRME – Global Prime Real Estate ETF
This is a solid example of a portfolio that is accessible for almost any investor. All ETF’s on the list are currently trading between $15 and $40 a share and all have low maintenance fees. A portfolio such as this gives you exposure to many asset classes rather than just several stocks.
Keep in mind that one part doesn’t necessarily mean one share; if your US stock ETF is trading at $20 and your gold ETF at $40, you would need to buy 4 shares of the US stock ETF to achieve the aforementioned 2 part US stock to 1 part gold ratio. If you only have a few hundred dollars to invest now, you may perhaps drop the commodities or corporate bond allocation. This portfolio is designed to give you access to uncorrelated securities on a budget, but know that every market environment is different, and correlation of assets, or lack there of, is not guaranteed.
Ray Dalio of Bridgewater Associates is famous in part for his “All Weather” portfolio. His portfolio is heavier on bonds than the sample portfolio I recommend, but the approach is similar. Uncorrelated securities give you most of the upside when markets are bullish, with limited downside risk when the markets take a turn for the worse.
Over the past 30 years, Dalio’s “All Weather” portfolio hasn’t lost more than 3% or so in any given year, and has only had a handful of down years over this period. In Tony Robbins’ Book, Money Master the Game, along with a lot of pep, Robbins touts a simplified version of the “All Weather” portfolio which consists of 30% US stocks, 40% long-term US treasuries, 15% intermediate treasuries, 7.5% gold, and 7.5% commodities. If during this time you had held only the SPY ETF, which tracks the S&P500, you probably would have felt diversified, but would have been sorely mistaken when your equity dipped substantially during the dot com bubble and dropped by a whopping 40% in 08’ alone. A lot of investors think they can handle those swings, but can you really?
The portfolio I recommend above is just that, a recommendation. You may choose different ETF’s or play with the asset allocations; maybe you’d like a little more bond exposure, or a bit more US or Emerging Market stocks in the mix. Either way, the takeaway is that US stocks and bonds alone won’t protect you in uncertain market environments, and don’t give you the upside that real estate, commodities, gold, or emerging market stocks can offer.
For example, gold is usually seen as a store of value among investors; a safe haven when inflation runs amuck or when the economic waters are murky. Typically, gold and stocks move in opposite directions. There are times however, when gold and stocks move together in unison, although that is the exception to the norm.
Rebalancing is also crucial: let’s look at the US stock and gold ratio in our sample portfolio, 2 parts to 1 part respectively. You enter your position when your US stock ETF is at $20 (4 shares = $80) and gold at $40 (1 share = $40), and after six months your US stock ETF has gone up to $27 a share and gold has been flat and is still at $40. Now your equity in US stocks is at (4 shares = $108), and gold at (1 share = $40). In this scenario, you would want to sell off 1 share of US stock, which would leave you with (3 shares = $81) keeping the 2:1 ratio intact. You would want to reallocate the $27 gain towards whatever asset class or classes need rebalancing. The ratios don’t need to remain exact, but it’s important to keep them relatively close to your portfolio plan. Rebalance in regular intervals, be it every month, three months, six months, or once a year.
In the long run, a smart mix of diverse asset classes will beat betting the house on the hot stock pick of the day. Whichever investments you choose for your own portfolio, make asset allocation your first priority. Focus first on asset classes, and let your individual security choices follow. Your wallet will thank you for it.