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Invest Smarter: Principles & Practices Part 4

| April 27, 2022
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At last, here we are folks, at week four of our Edu-blog series on the principles and practices of smart investing. Now it is time to talk about diversification and rebalancing! Exciting stuff, well exciting if you like setting your portfolio up for potential growth instead of potential loss. 

So, what are diversification and rebalancing, and do they go hand-in-hand? Just as the three disciplines of faith, patience, and discipline seem to flow together so well, so do asset allocation, diversification, and rebalancing. They all work together to position your investments for optimal outcomes in spite of human involvement! 

Diversification is simply the practice of mixing things up. So far we have mixed up our asset classes with asset allocation, now we have to stir the pot with what is in each of those asset classes. Essentially, diversification is investing in various industries, sectors, and countries within your asset classes. This practice helps keep your investments non-correlated, which is the second layer of defense against market and economic turbulence. Just as asset allocation has multiple asset classes that act differently from one another in different situations, diversification ensures that the holdings in each asset class act differently from each other in various situations. Asset allocation is non-correlation at the macro level while diversification is non-correlation at the micro-level. The idea is slow and steady growth, you never make a killing but you never get killed. Keep in mind that holding too many different positions in each asset class exposes you to the risk of over-diversification by spreading your assets too thin to actually perform at all for you. 

Now that your asset classes and the holdings within each class are positioned well, how do you keep them that way? Do you just leave them there and they always stay in the right percentages. If only that was true.

Enter, rebalancing.

What happens when our thoughtfully allocated and diversified portfolio gets out of whack and our percentages shift? Well, just as we do when we align the wheels on our cars so we can drive straight, we simply re-align or rebalance our portfolios so they stay in line with our investment objectives and risk tolerance. There are a couple of ways a portfolio can get out of alignment, typically gains or losses create different percentage weightings of that particular holding. 

So, say you have $100 or five shares of XYZ,  a technology company, but the company does so well that those five shares that were worth twenty dollars a share are now worth $40 a share. Now you have $200 worth of XYZ and without your involvement, your portfolio is overweight in technology, often considered a higher risk asset class, and no longer aligned properly with your risk tolerance. 

What’s an investor to do? Have no fear, rebalancing is here. 

With some quick adjustments, via buying or selling shares of the over or underweight holding, your portfolio’s allocations can be put back on track. Rebalancing is a non-emotional way of “selling high and buying low”. Pick a date, your birthday, anniversary,  or better yet, when you meet with your advisor (me) and be disciplined about rebalancing no matter the headlines.

There you have it folks, the three principles and three practices for smarter investing. I hope you’ve learned some new tricks to keep you sane while the markets and the world are doing whatever it is they are going to do. Remember, just tuck your head and stay focused, worrying will not earn you greater returns, in fact, it may cause you to take actions that can adversely affect your portfolio and your overall financial plan.

Until next time…

One last thought, I believe an educated investor is an empowered investor. If you like what you’ve read and think your friends and family can benefit as well, please share. 

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