In the first post on this topic, we defined diversification as spreading your investments among assets with differing return and risk potential. In this post, we’re going to discuss the benefits of diversification.
To keep a portfolio spread among different asset classes, you will need to rebalance it regularly. Otherwise, some investments will get out of alignment with your initial target asset allocation. Several studies show that rebalancing a portfolio at least once a year and preferably twice a year is required. There are two ways to rebalance a portfolio:
- Add money to the portfolio and purchase the asset classes that are below their targets.
- Sell securities that are above their targets and buy securities below their targets.
It’s this second action item that causes many investors to balk. When we discuss this tactic with some clients, we hear comments like this: “What? You want me to sell something that has gone up in value and buy something that has gone down in value. Are your crazy?”
I know it sounds counter-intuitive to sell winners and buy losers. However, yes this is what is required to have a diversified portfolio. The question is “Why?” Why would we ask someone to do something that sounds so odd?
The benefits of diversification are these:
- Diversification lowers risk or increases return potential. For example, if you have too much stock in your portfolio, your risk goes up, maybe to the point where you are not comfortable. If you have too much cash or too many bonds, your return potential is reduced.
- Another more subtle benefit of diversification is it forces you to reconsider your target mix when you rebalance your holdings and your portfolio goals. A mix that you chose when you were 25 may not be right when you’re 35. Your life situation changes over time and your goals may also change. Your investment goals and therefore your target mix needs to evolve with your life goals.
- Finally, a diversified portfolio provides peace of mind and confidence. When a major world event happens or when the stock market drops suddenly, a diversified portfolio allows you to weather the storm with less worry and you’re more likely to stay the course. If you rebalance regularly (once or twice a year), you will know the mix of assets is right for you.
One caution to mention: holding a diversified portfolio is not a guarantee for future returns. Investment markets move in un-foreseen and un-expected ways. Investing carries with it uncertainty and even a diversified portfolio can’t eliminate future surprises.
Next time: The Dangers of False Diversification