How Should You Diversify Your Portfolio?

Spend time talking with financial advisors and the conversation is likely to turn to the importance of having a diversified portfolio.

The right mix of stocks and bonds, mutual funds and exchange-traded funds and accounts with different tax treatments can help investors sleep at night. "If you're laid out properly it doesn't matter what the market does," says Scott Mann, president of Mann Financial Group in Houston.

The question becomes how to diversify a portfolio. There is no one-size-fits-all allocation model, says Tim Speiss, partner-in-charge of the personal wealth advisor practice at EisnerAmper in New York.

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The traditional basic allocation model is to have 60 percent of a portfolio in stocks and 40 percent in bonds, says Tim Courtney, chief investment officer of Oklahoma City-based Exencial Wealth Advisors. Pension plans favor this model, and investment firms such as mutual fund providers tailor their products toward this traditional benchmark, he says.

But, he adds, there's nothing magical about this model.

"It's really just tradition," he says. "You're tilting toward the position of higher returns but you're not going too far. You're not going crazy."

Under this scenario, 70 percent of the stock portion could be made up of a fund investing in large U.S. companies such as the Invesco Equally-Weighted S&P 500 Fund (ticker: VADAX) and a fund buying small U.S. companies like the Vanguard Small-Cap Value ETF ( VBR), he says. Another 20 percent could go to an international large-company fund such as the Schwab Fundamental International Large Company Index ETF ( FNDF) and the remainder allocated to an emerging market fund like the Vanguard FTSE Emerging Markets ETF ( VWO), Courtney says.

For the bond portion, an example would have 30 percent in a short-term bond fund such as the Vanguard Short-Term Corporate Bond ETF ( VCSH), 40 percent in a fund like the iShares Core U.S. Aggregate Bond ETF ( AGG), which holds intermediate to long-term bonds in addition to some short-term securities, and 30 percent in inflation-protected bonds such as those held by the Schwab U.S. TIPS ETF ( SCHP), he says.

Investors should make sure to rebalance those positions once a year, he says. That means selling a bit of positions that have done well and buying more of positions that have declined to get the portfolio back to its original percentages.

"Studies show that when you do that you get a rebalancing bonus," Courtney says. "You're buying low and selling high."

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For those who are less hands-on and don't want to put as much work into portfolio maintenance, there are investments called balanced or moderate strategy funds that offer one-stop shopping for diversification. But he says these are less of a good idea because they do not offer customization and they rebalance each day, which is not ideal.

While mutual funds can offer instant diversification, they can also have performance drag, says Larry Rosenthal, president of Rosenthal Wealth Management Group in Manassas, Virginia. While some parts of the fund may be performing well, other positions may be underperforming.

One allocation model could be 49 percent in stocks, 49 percent in bonds and the rest in cash, Rosenthal says. The fixed-income side could include high-yield and floating-rate funds, he says. The equities portion could be stocked with high dividend paying companies, a public real estate investment trust, an annuity and maybe covered-call writing, which is an options strategy, Rosenthal says.

Another model would place 25 percent in a Standard & Poor's 500 index mutual fund, 25 percent in U.S. small market capitalized companies and emerging markets, another fourth in short-term bonds and the remainder in a money market fund, Mann says.

However, for those investors who are suited to the stock market, a securities allocation like this should only be one part of a more broadly diversified portfolio, he says.

The other parts, at least for older investors, would be Social Security, a cash emergency fund and an income portion that might be a fixed annuity guaranteeing lifetime income funded with money rolled over from a retirement account, Mann says.

Deciding what model is right involves investors assessing their risk tolerance, time horizon, income needs and the proper tools to meet their objectives, Mann says.

Risk tolerance is a big question, Speiss says. One way to assess this is to consider how you would feel if you lost 20 percent of your investment shortly after you put it in the market. Would you do nothing, withdraw all your money or go straight into fixed-income?

In addition to diversification among fixed-income investments, cash and equities, it is also important to have product diversification between mutual funds and ETFs and investments that are actively or passively managed, Rosenthal says.

Tax diversification is also important, he adds, noting different strategies include taxable, tax deferred or non-taxable accounts.

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"The most important consideration when designing a portfolio," Speiss says, is "what am I expecting this money to do for me."

Matt Whittaker is a Colorado-based freelance journalist specializing in natural resources and outdoor sports and business coverage. In addition to U.S. News & World Report, his work has appeared in The Wall Street Journal, Barron's, Pacific Standard, VICE Sports, Backpacker and High Country News. He has reported on renewable energy, coal, oil, natural gas, metals and seafood companies from the Americas, Europe and Asia. When not writing, he enjoys skiing, rock and ice climbing, backpacking and bicycle camping. He is a certified wilderness first responder. You can follow him on Twitter @mattswhittaker or connect with him on LinkedIn.