As investors, we must take some risk to make any money in the markets. While it is true that cash in the bank doesn’t seem to have any risk, since it doesn’t rise and fall, changing interest rates cause its return to vary. And because the interest on cash is so low, the risk is that it won’t keep up with inflation.

Stock prices cycle up and down, and they all move more or less together. In a bull market most stocks rise, and in a bear market most fall, the only difference being one of degree. Precious metal prices also change in cycles, but usually not in synch with stocks, and likewise for bond prices. All of these assets have risks which must be managed.

A concentrated portfolio would be one that invested in only one asset class, say stocks. When stocks do well, that portfolio would shine. And when held for any very long period, stocks have made money. But when they do poorly it can be disastrous. Ask anyone who rode through the 50% drops in 2000 and/or 2009.

The opposite of a concentrated portfolio is a diversified portfolio, which is invested in multiple assets that are not subject to the same influences. Diversification of a portfolio is one of the key risk management techniques used by investors. It’s a main feature of what is called Modern Portfolio Theory (which really should get a new name. It’s been around since 1952, though it’s just as applicable today as ever).

In a diversified portfolio, at any point in time at least some of the investments should be paying well. For example, if we were to allocate some money to stocks, some to bonds, some to precious metals and keep some in the bank, we would then have a diversified portfolio that can better withstand a bad market in any one of those areas. It won’t be as exciting as owning just stocks when stocks soar, or just gold when it glitters. But it will also not suffer catastrophic drops when one of those markets goes bad, as they all do periodically. It’s easy to show mathematically that if you avoid losing a large percentage of your portfolio at once, your long-term cumulative returns will be higher.

option

A simple addition to the idea of diversification is periodic re-balancing of the portfolio. Let’s take a really simple portfolio made up of cash, stocks, bonds and gold in equal amounts to begin with, totaling $100,000. As time passes, these various investments will have different returns. After a period of time, say a year, their values will no longer be equal. To make the example simple, say that three of the assets were completely flat for the year and were each still worth $25,000 at the end. Meanwhile, one of the four assets (say stocks) doubled in value to $50,000.

At this point, stocks are no longer ¼ of a $100,000 portfolio. Their $50,000 value is now 40% of a $125,000 portfolio. This is great! But no bull market lasts forever. Let’s say that next year, the stock market drops back to where it started, and the other assets do nothing as well. At the end of year 2, we’d be back to the original portfolio value of $100,000.

But we could have done better than this, by re-balancing the portfolio after the first year. Rewind to the end of year one. We would calculate the amount that then represented 25% of the current portfolio value and shift money from one asset to the other so that they were all equal again. In our case 25% of $125,000 is $31,250. At the end of year two we would have sold enough shares of stock to bring our stock holdings down to this amount – we’d sell $50,000 – $31,250, or $18,750 worth of stock.

The $18,750 liberated from the stock holdings would then be distributed equally to the other three asserts, $6,250 each, bringing them each up to $25,000 + $6,250 = $31,250. Now onward to the end of year two.

Remember that in year two the stock prices dropped back to their original value, meaning they were cut in half after doubling in year one. So, our $31,250 worth of stock dropped by $15,625. The other three assets were unchanged once again. With our portfolio having been rebalanced though, we are not back where we started – we have a net gain of $9,375 for the two years. We gained $25,000 on our stocks the first year; then we “gave back” only $15,625 in year two, leaving us with a net profit.

The re-balancing, by itself, created a net return of 9.375% over two years compared to a zero return for buying and holding.

Setting up for year three, the portfolio now is worth $109,375. Twenty-five percent of that is $27,344. Our stocks now are worth $15,625, which is less than $27,344. Each of the other three assets is now worth $31,625, which is more than $27,344. We now transfer $31,625 – $27,344, or $3,906, out of each of those other assets. This gives us $11,718 in cash with which we can buy more stocks, and everything is equal once again. Rinse and repeat.

This example is very simplified. But the mathematical fact is that as long as the various assets in a portfolio change in value at different rates, and as long as none of the assets ever becomes completely worthless, rebalancing adds to overall returns and always pays more than simply buying and holding the individual assets. As time passes and more up-and-down cycles occur, the difference between a rebalanced portfolio and one that is not rebalanced expands dramatically. This makes sense when we realize that re-balancing forces us to sell assets after they have risen in price, and to buy them when they have dropped in price – in other words, to buy low and sell high.

This idea of strategic asset allocation and rebalancing can be a cornerstone of a solid wealth-building strategy. With this as a base we can build a comprehensive plan. This is just one of many elements of the Proactive Investing program. If you’re not already a member, please check it out.

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