Why Your Diversified Portfolio Still Needs a Lot of Maintenance
Key Points:
Diversified portfolios tend to experience a smoother ride; however, over an extended time horizon without proper maintenance, they can actually experience more volatility.
The primary goal of rebalancing is to bring the portfolio in line with the original target allocation and hence an acceptable risk level for an investor.
Aligning the risk level of a portfolio with an investor’s tolerance for it makes him or her more likely to endure market volatility and stick to their investment plan.
It is true: diversifying an investment portfolio by spreading it across different “asset classes” like stocks, bonds, real estate and others, is one of the most effective ways to manage the portfolio’s risk. Taking it a step further, diversifying within those asset classes across different countries would further improve risk management. Unfortunately, there is one problem with this approach: It requires a lot of maintenance to remain effective.
Before we address the maintenance part, let’s consider why diversification across different asset classes is effective to begin with. Different asset classes are, by definition, different from each other. As a result, they tend to experience divergent performance (i.e., low return correlation with each other) over a given period. This is actually desirable because a portfolio that holds assets that do not perform similarly will tend to experience less overall volatility.
Diversified portfolios tend to experience a smoother ride as the different asset classes within it produce different returns over time. However, over an extended time horizon, the portfolio may experience “drift” – over time, the riskier asset classes (i.e. stocks) will grow faster than the less risky ones (i.e. bonds), such that the portfolio drifts away from the original mix of assets (i.e., the target asset allocation) that was determined based on an investor’s risk tolerance and financial goals. Excessive drift from one’s target asset allocation will actually increase overall portfolio volatility as the portfolio’s stock allocation grows. This ultimately exposes the portfolio to greater stock market risk. (See Figure 1.)
To prevent excessive drift, maintenance – in the form of “rebalancing” – needs to be performed, particularly for well-diversified portfolios. Rebalancing involves selling some of the assets in a portfolio that have appreciated in value and buying the assets that have either lagged or depreciated. The primary goal of rebalancing is to bring the portfolio in line with the original target asset allocation, such that the portfolio returns to an acceptable risk level for the investor.
Aligning the risk level of a portfolio with an investor’s tolerance for risk makes him or her more likely to endure market volatility and stick to their investment plan. If a portfolio is not rebalanced, its risk can increase materially above an investor’s expectation. Then, if and when stock markets decline significantly, the investor is more likely to panic, abandon his or her investment plan, and jeopardize the chances of meeting his or her financial goals.
Rebalancing is a difficult thing to do because it is counterintuitive (i.e., selling assets that have performed well) and investors tend to incorporate their emotions into the process. The best approach is to do it in a disciplined way without emotion. As something that is ingrained in our investment philosophy, we regularly rebalance our client portfolios whenever necessary. Risk management is critical when it comes to keeping investors on track to meet their financial goals. A diversified portfolio is an excellent way to achieve this, but it requires a lot of maintenance.