The Art of Constructing an Investment Portfolio
Investing can be complex. The techniques and strategies available to investors are seemingly endless.
So how do we go about developing a portfolio that meets an investor’s risk and return expectations?
First, we must establish the goal: to increase potential return for a given level of risk. In other words, what combination of investments can deliver the highest level of return without introducing excessive volatility?
The answer can be quite simple. A significant component of constructing an investment portfolio comes down to diversification.
Diversification
The core philosophy behind sound diversification is owning uncorrelated or low-correlated assets - assets that move independently of one another. A highly correlated portfolio is one that holds securities which move in sync with one another. Positive years can be very positive, but negative years can be especially painful.
Regardless of the underlying investments, this is the fundamental idea behind diversification. A portfolio can be properly diversified by investing in companies or areas of the market that behave differently from one another. This can be achieved by allocating across various segments of the domestic stock market, developed international markets, emerging markets, different market capitalizations, and a wide range of sectors and industries. Some areas of the market exhibit low correlation, while others are highly correlated.
Consider a simple analogy. If you were buying companies in your local community, purchasing three copper mines would result in a high-risk, highly correlated portfolio. If copper prices decline, all three mines are likely to suffer. Now, if you had instead purchased a copper mine, a gas station, and a local engineering firm - you would have a diversified portfolio. Investment returns would likely be steadier, and overall risk much lower.
Over long periods of time, diversification can help reduce risk and meet the risk tolerance of an investor, while also potentially improving actual investment returns.
Choosing Investments
That said, diversification is not everything. Few investors are interested in owning a broadly diversified group of marginal investments. I certainly am not. Diversification loses its value if each individual holding lacks the ability to generate returns, whether through income, dividends, or growth. A marginal investment should never be purchased solely for the sake of diversification.
The proper process is to diversify capital among the best assets available to buy. Each holding should exhibit its own unique return potential. Some investments may be more volatile, with high growth expectations, while others may be selected for stability and income.
It is also important to recognize that correlations change over time. We saw in 2025 that many asset classes moved in tandem with correlations generally increasing. Favoring high-quality investments that can perform reasonably well across various market environments can help protect against shifting correlations.
Final Thoughts
There can be a tendency to overdiversify. Beyond a certain point, adding additional holdings provides diminishing diversification benefits. Taken to an extreme, Charlie Munger has suggested that holding three exceptional businesses is sufficient diversification. The broader takeaway is that when portfolio holdings are high quality, an excessive number of positions may be unnecessary.
The concepts discussed here are intentionally high-level. I recommend reviewing your portfolio with a financial advisor to ensure that it is aligned with your long-term goals.
-Bill Rautiola, RICP®, AIF ®, PPC ®
This material is for general information and educational purposes only and is not intended to provide specific advice or recommendations for any individual. Investing involves risk including the loss of principal. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
