The mix of "best" investments changes

For most investors, their portfolio starts out with an allocation among a few different asset classes. There may be large and small US equity, US and foreign debt, large and small foreign equities, real estate and so on. The goal for most investors is to start with a portfolio that is broadly diversified to give as much exposure to different asset classes as desired.

The theory is by holding asset classes that may behave differently given market conditions and economies, the portfolio may give you a smoother ride en route to your performance goal for that particular collection of investments. This is the concept of correlation. A low correlation means that there is a low expectation that two asset classes may behave similarly while a high correlation means that it is more likely that two asset classes will behave similarly.

Diversification and the efficient market theory has guided the overwhelming majority of investors to act this way since the 1950’s. Yet thinking back to 2008 when most markets suffered, the comment that diversification doesn’t work was as common as saying good morning to people on the way into your office.

The claims from 2008 were correct. In 2008, diversification did not work too well. That failure wasn’t rooted in the modern portfolio theory of diversification; it was because correlations of many major asset classes all drifted together. Asset classes that had historically behaved very differently during normal market conditions behaved very similarly during the market meltdown and stress of 2008.

The facts surrounding volatility and correlation matter because it can enhance or mitigate the intended results of rebalancing a portfolio.

Rebalancing means that the investor brings the portfolio back into line with the desired allocation of asset classes. Some rebalance automatically at regular intervals and others will rebalance when they feel that the allocations should be rebalanced. By rebalancing, you are hoping to spread your risk and re-diversify your portfolio.

Rebalancing may add another benefit. When you sell those holdings that are now occupying more space in the portfolio than you’d like, you are likely selling holdings with gains. When you buy holdings that occupy less space in the portfolio than you’d like, you may be buying low. Whether you rebalance on regular intervals or as you feel it is warranted, take a second look to be sure that your portfolio is in fact diversified.

Just because you own many investments with different names doesn’t mean that they are very different. 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.

What is does do is to allow you to participate in many different asset classes. Don’t beat yourself up for having too little in a hot asset class or when one selections is going through a rough patch. All markets rise and fall, and over the long run, we want to participate in the rises and hope that the downturns don’t wipe you out.