How to Build a Diversified Portfolio

When the U.S. stock market is rallying--as it did for much of the past two decades--portfolio diversification falls to the wayside for many investors. After all, if U.S. stocks are doing well, why worry about having a diversified portfolio?

When U.S. stocks struggle, though, as they have this year, the portfolios of many investors struggle, too. It's at times like these that some investors seek out different types of assets to diversify their portfolios.

The problem is, building a diversified portfolio shouldn't be something an investor does only when U.S. stocks face headwinds. In fact, portfolio diversification doesn't always work as investors might expect over brief periods of time.

"One of the cruel facts about portfolio diversification is that it may or may not pay off in any given period," admits Morningstar portfolio strategist Amy Arnott. In fact, during periods of market stress, many asset classes drop in tandem. This year, for instance, both U.S. stocks and U.S. bonds endured losses at the same time.

Despite that, we think diversification remains one of the few "free lunches" in investing. But we also think crafting an effective diversified portfolio is becoming more difficult to do.

In this special report, we answer some of the key questions investors have about what portfolio diversification is, how to achieve it, and why effectively diversifying an investment portfolio may be getting harder to do in the face of rising interest rates and inflation. We also share some new Morningstar research that drills down into how good particular asset classes, subasset classes, and factors have been at providing diversification to a U.S. stock portfolio.

What Is a Diversified Portfolio?

The basic concept of portfolio diversification is spreading your money among a variety of different investments in an effort to improve your risk-adjusted returns.

Some would argue that simply by owning a managed product, such as a mutual fund or an exchange-traded fund, an investor already has achieved some level of diversification. And that’s true: Because mutual funds and ETFs are composed of baskets of stocks, bonds, or some combination thereof, they provide more diversification than owning a single stock or a single bond. Put another way, owning a basket of securities via a fund reduces the "per issue" risk that comes with owning just one security.

However, when most talk about portfolio diversification, what they really mean is spreading out your money not just among various individual securities, but among securities that tend to behave differently from each other. For instance, an index fund that tracks the S&P 500 is diversified in the sense that it owns many stocks, but it isn't as diversified as something like a world-allocation fund, which owns stocks and bonds across various geographies.

Download: Morningstar's Diversification Landscape Report

The Advantages of a Diversified Portfolio

Portfolio diversification is rooted in something called Modern Portfolio Theory, which is a strategy that focuses on investing in different asset classes as a way to reduce a portfolio's overall risk while achieving the best return possible. "As Harry Markowitz first established in his landmark research in 1952, a portfolio's risk level isn't just the sum of its individual components but also depends on correlation, or how the holdings interact with each other," explains Arnott.

Theoretically, by owning holdings that behave differently from one another (in investing lingo, that means finding investments that have low or negative correlations with each other) an investor can build a portfolio with risk-adjusted returns that are superior to those of its individual components.

Watch: Diversification Deep Dive New research suggests that diversifying a portfolio is becoming more challenging. Here's what to focus on.

The Parts of a Diversified Portfolio

A diversified portfolio often includes three primary asset classes:

• U.S. stocks
• International stocks
• Bonds

Investors will determine how much they should dedicate to each asset class based on things like their investment time horizon, investment goal or goals, and risk tolerance. Various sources--including Morningstar--provide asset-allocation benchmarks that investors can use to build an appropriate asset allocation based on their life stage.

Read more: Which Bond Types Provide the Most Diversification for Stock Investors? Stock and bond correlations have risen recently amid interest-rate changes and inflation.

Is International Diversification Necessary? The diversification benefits haven't been obvious in recent years, but there's still a case to be made.

More complex diversification strategies may call for diversifying by investment factors. Two of the most popular stock factors are based on company size (large companies, midsize companies, and small companies) and style (value, growth, or a blend of the two). Such strategies may also suggest taking small positions in things like gold, real estate, commodities, alternatives, and even cryptocurrency.

Read more: Does It Pay to Diversify by Factor? A general upward trend in correlations has reduced the diversification value, but recent performance has shown more divergence.

How Do Alternatives Fit Into a Diversified Portfolio? It depends on the strategy.

Is Cryptocurrency Really a Portfolio Diversifier? Cryptocurrency has a low correlation with traditional asset classes, but correlations often spike during down markets.

Are Sector Funds Worth Owning? The data suggest that industry-specific funds don't do much to diversify a U.S. equity portfolio.

Does Portfolio Diversification Work?

As mentioned earlier, diversification may not pay off during short time periods, when all boats may be rising or, conversely, sinking. Further complicating things: The landscape for both interest rates and inflation has shifted in 2022.

"After decades of relatively low inflation and generally declining interest rates, both measures have shown signs of a fundamental regime change," observes Arnott. "As a result, the previously ideal conditions for stock/bond correlations are no longer in place, and correlations between stocks and investment-grade bonds have already flipped to positive territory. That, in turn, reduces the diversification value of bonds from a portfolio perspective."

Though diversification has its limitations and may be becoming more challenging in the face of rising rates and inflation, we think it's still worthwhile.

"I wouldn't get fixated on just inflation risk, just interest-rate risk," says Morningstar's director of personal finance and retirement planning Christine Benz. "Remember that there are a number of different risks that you're trying to defend against. And there might be environments where … bonds will be very valuable indeed. So, I do think that thinking about a balanced portfolio, thinking about your life stage and your proximity to needing your assets to draw upon should be key guideposts as you think about positioning your portfolio today."

Read more: Why Diversifying Your Portfolio Is Getting Harder Spreading out your bets makes sense, but it doesn't always pay off.

What Do Rising Interest Rates Mean for Diversification? A rising interest-rate environment may increase correlations between stocks and bonds.

What Rising Inflation Means for Your Portfolio Continued higher inflation would have far-reaching implications for portfolio diversification, but there's no need to panic.

How an Investor Can Build a Diversified Portfolio

Investors can take a few different routes to build diversified portfolios. No matter the specific route, though, we suggest most investors use managed products, such as a mutual funds or ETFs, for diversification. Because managed products invest in baskets of securities, they're already reducing "per issue" risk for you.

Those who'd like to minimize the work involved in building a diversified portfolio could do well with a target-date fund. Target-date funds typically provide exposure to the three main asset classes and often a few others in moderation. They also adjust their asset allocations over time to favor lower-risk investments as they approach their target dates.

Investors who would be more hands-on with their diversification might instead focus on what's often called "the three fund portfolio"--a simple portfolio that consists of one core U.S. stock fund, one international-stock fund and one fixed-income fund. All three funds should be low-cost and well diversified.

Read more: Target-Date Fund Investing in 2022 Learn how these investments work, what to look for when choosing one, and which ones earn our highest ratings.

The Best Core Stock Funds for 2022 These large-company-focused mutual funds and ETFs blend growth stocks and value stocks and earn Morningstar Analyst Ratings of Gold.

The Best International-Stock Funds for 2022 These international mutual funds and ETFs all earn Morningstar Analyst Ratings of Gold.

The Best Taxable-Bond Funds Here are the highest-rated mutual funds and ETFs across a series of Morningstar's taxable fixed-income categories.