The core principle: correlation
The key insight is correlation — the degree to which assets move together. If two assets are perfectly correlated (+1), holding both provides no diversification benefit. If they are perfectly negatively correlated (−1), combining them eliminates risk entirely. Real assets fall somewhere between. The goal of portfolio construction is to combine assets whose correlations are low enough that the combined portfolio's volatility is less than the weighted average volatility of its components. This is diversification — getting something for nothing, in Markowitz's formulation.
Asset allocation: the most important decision
Academic research consistently shows that approximately 90% of long-term portfolio returns are explained by asset allocation — the split between stocks, bonds, property, cash, and alternative assets — not individual security selection. Getting the allocation right matters far more than picking the best stock within equities. The right allocation depends on your investment horizon, risk tolerance, and financial goals. A 25-year-old saving for retirement can tolerate more equity risk than a 60-year-old one year from drawing down.
Building in practice: the steps
First, determine your target asset allocation based on risk profile and horizon. Second, choose low-cost, broad index funds to implement each allocation (global equity, government bonds, corporate bonds, property). Third, ensure geographic diversification — not just across sectors but across countries. Fourth, rebalance periodically (annually is sufficient) to restore target weights as markets drift. Fifth, minimise cost: every 0.1% in additional annual fees compounds into substantial lost wealth over decades.
Correlation risk: the hidden danger
The danger in portfolio construction is that correlations are not stable. During market crises, correlations across asset classes often spike toward +1 — the very moment you most need diversification, it fails. Equities and corporate bonds often sell off together in a crisis. This is why true diversification requires genuinely uncorrelated assets: government bonds from different countries, real assets, gold, and in some cases alternative strategies.
"Diversification is the only free lunch in investing." — Harry Markowitz, Nobel Prize-winning economist and father of Modern Portfolio Theory
What this means for you
For most individual investors, a simple three-fund portfolio (global equity index fund, bond index fund, cash) gets you 90% of the way to optimal portfolio construction at minimal cost and complexity. The marginal benefit of adding the 15th asset class is small; the marginal cost in complexity and fees can be significant. Start simple, keep costs low, and let diversification and compounding do the work.