Properly Diversify a Portfolio (Beginner)

Introduction

This article is to address the often asked question "Is my portfolio diversify enough?". This is more for the someone who had just start DIY investing and trying to create their own porfolio. Thus, we will be focus more on creating a portfolio using ETFs.

First step

When people talk about diversifiction, first thing that come to mind "Get an board based ETF!". Job done! While getting a board based ETF will help to eliminate Unsystematic risk eg. Individual company going bankrupt. But it cannot mitigate systematic risk (market risk).

Market risk cannot be mitigated by diversification, it can only be mitigate by allocating to less correlated investment or some hedging strategy.

Fund overlap

Tool: https://www.etfrc.com/funds/overlap.php

Many time, new investor will choose a bunch of ETFs to form a portfolio. However, many of the fund have overlapping holdings. Example one may hold VTI & VOO in their portfolio, but both ETFs had actually 80% of the holding overlapped. Too much overlapping will lead to over concentration on individual holdings. Therefore, giving a false sense of diversification.

A proper diversification should have as little overlap as possible, in my opinon, anything more than 30% overlap is over weighted. However, you should not soley based on this metric to decide whether to included the ETFs into your portfolio. You should still ensure if the ETFs suit your style and financial goal. Personally, although ARKK and VOO had very little overlap, i will not include in my portfolio because it don't suit my style.

Correlation

Tool: https://www.portfoliovisualizer.com/asset-correlations

The other metric people often use is correlation. Basically it describes the degree to which the ETFs move in coordination with one another. The correlation rating range from -1 to 1. If you still dont understand, it doesnt matter, just some mathematical jargon.

Just remember

• NEVER pick ETF with negative correlation (in practical)
• A 0.7 to 0.5 is good enough

Portfolio Weightage

Tool: https://www.portfoliovisualizer.com/backtest-portfolio#analysisResults

After you selected what ETFs you want to buy, the next question how much to buy. To do that you can do a backtest. Past performance does not represent future performance, but it gives you a feel how the portfolio will perform. The tools allow you to create up to 3 portfolio, you may adjust the weightage accordingly.

2 things you should take note the returns (CAGR) and the risk (Stdev) to strike a balance that fit you.