How to Build a Diversified Portfolio

Last Updated Aug 23, 2011 7:04 AM EDT

Writing for The Wall Street Journal, Jonathan Clements noted: "Indexing is a wonderful strategy. It's a shame most folks get it wrong." He was referring to his belief that most investors who use index funds limit themselves to funds that mimic the S&P 500 Index. Today, you'll see how expanding on a simple S&P 500 indexing strategy can improve results. It'll also show you how to outperform the vast majority of institutional investors.

The power of modern portfolio theory will be demonstrated by following the performance of a "control" portfolio, with a traditional asset allocation of 60 percent equities and 40 percent fixed income over the period 26-year period, 1975-2010. This period was chosen because it's the longest for which we have data on the indexes used. Throughout this example, we'll keep the same 60 percent equity/40 percent fixed income allocation.

We will begin with the S&P 500 for the equity allocation and the Barclays Capital Intermediate Government/Credit Bond Index for the fixed income allocation.

First, we'll see how the portfolio performed if an investor had the patience to stay with this allocation from 1975 through 2010 and rebalanced annually. We then demonstrate how the portfolio's performance could have been made more efficient by increasing its diversification across asset classes. Let's see how the first portfolio looked.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.