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A diversified portfolio can create a more comfortable environment for investors to weather the ups and downs of the stock market. A well-diversified portfolio typically carries lower risk while maintaining potential upside. Investors are more likely to stay the course and remain invested when their portfolio’s volatility stays within their comfort zone. Each person has his or her unique risk tolerance level. The goal is always to remain invested through all market cycles.

For example, a diversified portfolio that captures 50% of market declines and 60% of market gains may help ease the anxiety of a risk-averse investor. Lower portfolio volatility increases the likelihood that an investor will remain invested during both bull and bear markets. In the long run, slow but steady wins the race toward financial goals.

There are many ways to diversify. One simple approach involves two key steps:

Historically, U.S. long-term government bonds have provided valuable diversification due to their negative correlation with equities during economic recessions. However, from January 2020 to December 2024, U.S. government bonds had a negative Sharpe Ratio of -0.53. In my prior research, I’ve discussed the “Simple 50/50 Model,” which allocates 50% to iShares Core S&P 500 ETF (ticker: IVV) and 50% to iShares 20+ Year Treasury Bond ETF (ticker: TLT). This model was effective during the financial crisis and the COVID-19 pandemic. However, over the last four years, this model would have underperformed due to the poor risk-adjusted return of long-term bonds. We can’t always rely on historical correlations and performance, while historical data is there to analyze, the future is notoriously difficult to predict. It’s wise to be conservative and account for potential correlation breakdowns and unexpected events. Long-term US Government bonds may still provide future downside protection during the economic slowdown, whereas Gold is more of an inflationary hedge.

For instance, when analyzing the past four years of major asset classes, the clear winners have been:

Interestingly, Gold’s volatility (Standard Deviation = 15.49) was about 40% lower than that of NASDAQ-100 (Standard Deviation = 25.64).

The worst-performing sectors were in fixed income:

For the past four years, the optimal mix for building a portfolio with the highest risk-adjusted return has been 48% in NASDAQ-100 and 52% in Gold (IAU). This allocation produced a Sharpe Ratio of 0.73 and a Standard Deviation of 15.82: a high risk-adjusted return with lower volatility than either asset class alone (see Table 3).

If our goal is to minimize volatility, one solution based on Excel optimization to minimize variance might include the following asset allocation:

This portfolio results in a Standard Deviation of 13.45 and a still-attractive Sharpe Ratio of 0.55 (see Table 4). Of course, allocating 68% to Gold may not be practical in real-world investing, given future uncertainties. You may want to diversify further by adding US long-term government bonds, for example. If we have an economic recession, investors will demand safety and buy US Treasury Bonds, pushing the prices higher.

Let’s take diversification a step further, this time at the expense of the Sharpe Ratio. By adding long-term U.S. government bonds, we create a new, more diversified portfolio. The asset allocation of this portfolio is as follows: US Long-Term Treasuries (TLT) 36%, Total US Market (VTI) 23%, MSCI Europe (IEV) 5%, and Gold (IAU) 35%. The standard deviation drops to 11.32, but this comes at a significant cost of a lower risk-adjusted return. The new Sharpe Ratio is almost zero at 0.03 (see Table 5). This portfolio has the lowest standard deviation among the three models we’ve reviewed, but it is the least efficient and may not compensate for the risk taken. Portfolios one and two are much better choices.

Disclosures:
The analysis is based on historical data and future expectations that may not be correct. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor before making an investment decision. Neither ECNFIN.COM nor its author is responsible for any damages or losses arising from any use of this information. Past performance doesn’t guarantee future results.

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