How to create a diversified portfolio

The other day I was trying to create a diversified investment portfolio for my 401(k) account. And I was shocked to see how bad the existing allocation was. Back when the financial equivalent of self realization had not dawned on me, I had done a very naive allocation by just sprinkling the money into various investment options in different categories given to me. The categories that were given were as follows;

1. Short term fixed income
2. Fixed Income
3. Long term equity
4. Small and Medium cap equity
5. International Equity
6. Natural Resources

There was also a fund in small and medium cap category which was in real estate asset class.

I would have preferred to be given ETF choices in these asset classes. Unfortunately my company only allows mutual funds in their 401(k) account. I am hoping this situation will change soon. So basically given a bunch of mutual funds in these categories I had to do an asset allocation. At the time I took a D-I-Y approach and thought naively that by just putting 10 to 15 % in various options in different categories, I would have created a diversified portfolio.

Now that financial self realization has taken place, I went back to my 401(k) account and tried to actually measure how diversified my portfolio was. To my dismay, when I entered the portfolio in the diversification score module, I found out that my portfolio was less optimally or under diversified. The problem was that I did not realize the importance of the concept of correlations. Choosing many investments that are all correlated is no diversification. Most of us fail to realize that and naively believe that just sprinkling money into many investments and not putting all your eggs in one basket is diversification.

Solution: I went back to the ETFscale toolkit and tried to find a portfolio of n ( n = 5 or 6 or 7) mutual funds out of 20 that I was given, which will give me the highest diversification score. This helped me to come up with a optimally diversified portfolio.

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