A portfolio is simply a collection of assets. You may already be familiar with the term “an artist’s portfolio,” which is a sample of the works the artist has completed. Similarly, a model’s portfolio contains pictures of him or her in a variety of poses. An investment portfolio refers to the set of assets in which you have invested your money with the expectation of earning a return on them in the future. These assets may include stocks, bonds, mutual funds, real estate, precious metals, and collectibles, among other items. The important thing is that you don’t put all your eggs in one basket, as the saying goes. By investing in more than one asset, you can achieve the same return on your investment, but reduce your risk exposure significantly.
The return on a portfolio is a simple weighted average of the return on each of the assets held in the portfolio, where the weights are determined by the percentage of money you have invested in each asset:
Return portfolio= (weight1 x return1) + (weight2 x return2) + (weight3 x return3) + . . . .
As an example, assume you have invested a total of $20,000 in the following assets with the returns indicated:
|Asset||Price each||Number of shares/bonds
(= Amount invested ÷ $20,000)
|5-year Treasury bond||$1,000||6||$6,000||30.0%||4%|
|Uber (UBER) stock||$ 33||100||$3,300||16.5%||20%|
|American Airlines (AA) stock||$ 17||100||$1,700||8.5%||12%|
|Honda (HMC) stock||$ 30||100||$ 3,000||15.0%||10%|
|Baron Real Estate Fund||$ 20||200||$ 4,000||20.0%||8%|
|General Electric (GE) stock||$ 10||200||$ 2,000||10.0%||5%|
Using the formula, the return earned on this portfolio is:
Return = (0.3 x 4%) + (0.165 x 20%) + (0.085 x 12%) + (0.15 x 10%) + (0.20 x 8%) + (0.10 x 5%)
Looking at the above example, you may consider you might have been better off had you invested all your funds in Uber stock. And you would have—after the fact. The problem is that we don’t have a crystal ball that tells us what the future return on a particular investment will be, which is precisely why a wise investor invests in more than one asset. If, for example, Uber had been named the defendant in a major lawsuit during the holding period used above, it’s unlikely that it would have returned 20%; in fact, the return earned might have even been negative. The uncertainty regarding the return on an individual asset or portfolio of assets is referred to as its “risk.” The good news is that the risk of a portfolio of assets is not just a simple weighted average of the risk of each individual asset. The risk of a well-diversified portfolio is actually less than the weighted average risk of each of the individual assets in the portfolio. You can construct a well-diversified portfolio by investing in carefully selected mutual funds or exchange-traded funds (ETFs), but you can also do so by investing in individual stocks and bonds, and you don’t need a ton of money to eliminate all the asset-unique risk from your portfolio. In fact, a portfolio of just five assets can eliminate a lot of the individual asset risk, and a portfolio of 15 to 20 well-selected assets can achieve maximum risk diversification.
The Correlation Coefficient
The secret lies in choosing those assets wisely. To achieve maximum diversification, you want to select assets with returns that are uncorrelated or have very low correlations with each other. If the returns are negatively correlated, that’s even better, but that’s a rarity. Correlation is a mathematical measure of how closely two returns move together. The correlation coefficient will always be a number between, and including, -1.0 and +1.0. A correlation coefficient of +1.0 (a perfect positive correlation) indicates that the returns of the two assets always move together. If one is up, the other is up; if one is down, the other is down. A correlation coefficient of zero means that there is no relationship between the returns of the two assets. If one is up, the other may be up, down, or unchanged. And if the correlation coefficient is -0.1 (a perfect negative correlation), it means that if the return on one of the two assets is up, the return on the other will also be up, and vice versa.
But you don’t actually have to pull out a calculator as you select the assets in which you want to invest. You can do so intuitively. For example, assume you are considering investing in just two individual stocks. Do you think dividing your money between American Airlines and Delta Airlines would enable you to diversify a lot of risk? Probably not. You might correctly assume that since companies in the airline industry are similarly affected by various economic and industry-specific events, the returns of American and Delta probably have a very high positive correlation—they move together most of the time. What about American Airlines and Choice Hotels? Well, they’re not in the same industry, but they are in related industries. Their returns probably don’t move together as closely as those of American and Delta, but they are likely to be fairly positively correlated. Now think about American Airlines and Hasbro. They are both U.S.-based companies, so their returns will move together somewhat, but it is unlikely that the returns on an airline and a toy manufacturer will have a high positive correlation. Of the three scenarios, investing in these two stocks would afford you the most risk diversification. Adding bonds and real estate (which you can do by investing in a Real Estate Investment Trust) to your portfolio will further diversify your risk since the returns on these two asset classes have a very low positive correlation with the returns on corporate stocks in general.
A Portfolio of Funds
Some people believe that putting all their money in an S&P 500 index mutual fund that invests in a large number of big-company domestic stocks provides them with maximum risk diversification. Although it certainly provides a lot of risk diversification, the stocks of large U.S.-based companies tend to move together to a degree. To be even better diversified, consider investing at least a small percentage in firms with less than $2 billion in market capitalization (otherwise known as “small caps”) and another small portion in foreign stocks. This increases the risk diversification of your portfolio since the returns of smaller companies and foreign companies do not always track the returns of large-company stocks, and it also increases the return you can expect because the expected returns on these two investments are often higher than those of large-company stocks.
The goal of investing is to maximize your expected return while minimizing your risk exposure. This can only be done by investing in a portfolio of well-selected assets. We can never eliminate all the risk involved since there is some risk that all firms face, even foreign-based ones. A recent example of this is the Coronavirus (COVID-19) pandemic. All firms worldwide have been adversely affected by this event, although some more so than others. Streaming service firms, such as Netflix, and companies that offer online shopping, such as Amazon, have not been as negatively hit as firms in the travel and entertainment industries. However, we can eliminate the asset- and industry-specific risk by investing in a variety of asset categories (i.e., stocks, bonds, real estate) and also by dividing our funds among a number of assets within the same category.