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As Ray Dalio of BridgeWater Associates put it, investors "should have a properly balanced portfolio", by which he means balancing in terms of risk rather than in terms of dollars invested. However, too frequently investors overlook their portfolio risk characteristics and focus on notional amounts instead, not realizing that even popular portfolios like 60/40, equal weight or Ivy are typically inefficiently diversified.

As an example, let's consider a simple hypothetical portfolio with 50% invested in US stocks (NYSEARCA:SPY) and 50% in emerging markets stocks (NYSEARCA:EEM). A quick analysis of such a portfolio on a freely available investor tool InvestSpy reveals that over the last 5 years roughly 62% of portfolio risk came from EEM and only 38% from SPY:

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This means that over 60% of portfolio volatility was accounted for by EEM. To alleviate the imbalance, let's overweight SPY to 60% and underweight EEM to 40%. The same kind of analysis now shows an almost even split between portfolio risk contributions. Furthermore, not only the change in allocations balances out risk contributions, but it also decreases the overall portfolio volatility and value at risk:

(click to enlarge)

Performance-wise, both portfolios move almost identically and yield similar returns. The chart below shows that the 50% SPY / 50% EEM portfolio gained 20.6% over the last 5 years, whilst the 60% / 40% version of it appreciated by 23.4%. Therefore, the latter portfolio achieved a slightly higher return and did that in a more "balanced" fashion.

(click to enlarge)

Of course, the performance in terms of returns would have been different had EEM outperformed SPY. However, investment returns are extremely difficult to forecast ex ante and investors are frequently better off by simply focusing on portfolio risk parameters, which tend to remain more stable over time.

A similar kind of analysis could easily be extended to larger portfolios that include more asset classes. You will be surprised to see how far off the balance some commonly referred portfolios are (e.g. 60% stocks / 40% bonds).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.