diversificationDoes Diversification mean that some part of my portfolio will not perform well? It sure does!

Asset Class Diversification is one of the central components of both modern portfolio theory and a well-designed portfolio. Everyone agrees that a prudent investor should not “put all of his eggs in one basket.” Modern Portfolio Theory teaches us that there are 19 distinct asset classes. Asset class diversification is important for portfolio design because no one knows in advance which of those 19 asset classes will perform well (the “stars” of the portfolio), and which will not perform so well (the “dogs” of the portfolio). So, we spread our investment dollars over the 19 asset classes.

Lack of Asset Class Correlation is another integral aspect of prudent portfolio design. In other words, you do not want the various asset classes within your portfolio to move in lock-step with all other asset classes. A very basic example would be the lack of correlation between stocks and bonds. Generally, when stocks soar, bonds sag (or underperform). Therefore, we would say that stocks and bonds have a low correlation to each other.

Proper diversification and lower-correlated assets allow us to design a portfolio that is more “efficient”. An efficient portfolio is a portfolio that is taking the proper amount of risk for an expected return. Often when we analyze a client’s portfolio, we can show the client how to either:

(1.) Achieve the same amount of anticipated return for lower risk; or
(2.) Achieve a higher rate of return if they are willing to accept the amount of risk in the portfolio.

These goals are achieved through proper diversification and lower-correlated assets.

As a result of proper portfolio design, the portfolio will always have some asset classes that are performing well and others that are not performing well. Through periodic re-balancing we are able to sell the portfolio positions that are doing well and purchase those that are not performing so well. Thus, we can sell HIGH and buy LOW while bringing the various asset classes back to their target allocations.

Therefore, am investor needs to understand that in a well-diversified portfolio, there will always be some asset classes that are not performing as well as others. This is because no one can predict beforehand which asset classes in a given time frame will perform well and which will not. The real danger to the investor is in not fully understanding diversification and becoming tempted to chase recent performance by investing in those asset classes which have been “HOT”. An investor who pursues this method of investing could be undermining his long-term financial goals.